Shareholders and Business Ethics

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Today’s Lecture
Discuss the shareholder as a key stakeholder in business
Ethical issues

in Corporate Governance
Shareholders and corporate social responsibility

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Introduction
Ethics and CSR often seen as protection of stakeholder interests from

shareholder primacy
But shareholders (a) can be victims of unethical behavior too, (b) can choose to voluntarily side with stakeholder interests
The rights of shareholders: ethical responsibilities of governments, firms and financial markets toward shareholders
The ethical values of shareholders: shareholders’ goals and interests beyond profit maximization
Socially responsible investing (SRI)
Shareholder activism

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Owners and Control
Traditionally ownership = control
Up until the early 20th century,

firms were generally run by their owners
Modern corporations are more often managed (controlled) by “agents” (managers) who have a fiduciary duty to fulfil the goals and mission given them by its “principals” (shareholders)
Exceptions exist: many SMEs and family-owned business, and even some corporations, are still run by their owners or primary shareholders

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Owners vs. Shareholders
Often used interchangeably
However, a corporation is a legal

entity (“artificial” person)
Corporation assets are owned by the corporation, not shareholders
Employees are employed by the corporation, not shareholders
Publicly traded corporation: distributed (dispersed) shareholding (esp. in Anglo-American model)
As distribution of shareholding increases, shareholders become less “owners”, managers become more powerful

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Corporate Governance
“Corporate governance describes the process by which shareholders seek to

ensure that ‘their’ corporation is run according to their intentions. It includes processes of goal definition, supervision, control, and sanctioning.
In the narrow sense it includes shareholders and the management of a corporation as the main actors, in a broader sense it includes all actors who contribute to the achievement of stakeholder goals inside and outside the corporation.”
Parkinson (1993: 157)

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Shareholders’ rights
The right to sell their stock
The right to vote in

the general meeting
The right to certain information about the company
The right to sue the managers for (alleged) misconduct
Residual rights in case of the corporation’s liquidation

Does NOT include a right to a certain amount of profit

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Shareholders’ expectations
To be able to make informed investment decisions, shareholders need

proper information
Transparency: completeness, understandability, and correctness in information
Markets and investment decisions also require a certain level of trust
Trustworthiness of management: competence and integrity

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Ethical Issues
Agency problem: Misalignment of interests of agents and principles
Opportunistic

behavior by managers (e.g. increase bonus, power & prestige, or value of stock options) can lead to a variety of unethical and/or illegal behavior:
Accounting fraud
Detrimental M&As
Excessive executive compensation
Insider trading
All at the expense of shareholder value

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The Board of Directors
A separate body that supervises and controls management

on behalf of shareholders
Two types of directors:
executive directors: are actually responsible for running the corporation (e.g., CEO, CFO, COO, etc.)
non-executive directors are supposed to ensure that the corporation is being run in the interests of shareholders (aka independent or outside directors)
Drawn from outside the corporation
No personal financial interest in the corporation
Appointed for limited time
Competent to judge the business of the company
Sufficient resources to get information

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Corporate Governance
Anglo-American model

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Corporate Governance Models around the World

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Corporate Governance Problems
Numerous reasons why corporate governance arrangements fail too work:
CEOs

who have too much power (CEO & Chairman positions held by the same person)
Directors’ lack of independence (conflicts of interest)
Failure of directors to stand up to executives (lack of courage or strength)
Auditors want to maintain a good relationship with management (conflict of interest)
Auditors also offer consulting services to firm (conflict of interest)

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Corporate Governance Reforms
In the wake of alarming corporate scandals, CG reforms

have been introduced in the US and most European countries. These tend to focus on:
Separation of CEO and Chairman positions (often recommended but not required)
Number or proportion of independent outside directors
Independence of audit committee
Independence of compensation committee
Disclosure of compensation
But CG problems persist

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Lehman Brothers
Lehman Brothers and Goldman Sachs had similar boards
Both had made

many recommended changes
Lehman Brothers declared bankruptcy in 2008, during the Global Financial Crisis
Why did its board fail to prevent this disaster?

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Whistleblowing
When an employee makes information about misconduct by their employer public

Many corporate (and government and NGO) scandals came to light thanks to whistleblowing
Whistleblowing directly to the press or the public is becoming more common

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Examples of Whistleblowing
Some recent and prominent examples of whistleblowing include:
Jeffrey Wigand

revealed that tobacco companies were fully aware of the harmful health effects and addictive nature of smoking cigarettes
Sherron Watkins, Vice President of Corporate Development, helped expose accounting fraud at Enron
Cynthia Cooper, Vice President of Internal Audit, exposed a $3.8 billion fraud at WorldCom
Edward Snowden

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Whistleblowing
Whistleblowing can be facilitated by creating telephone hotlines that allow employees

to anonymously “tip off” senior managers or independent directors
Anonymity is important because whistleblowers face many risks and hardships
Some countries, but not all, offer legal protection for whistleblowers
In some countries whistleblowing is financially rewarded

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Whistleblowing Example
Sherry Hunt was a vice president and chief underwriter at

Citibank
In 2011 she blew the whistle on her employer for fraud
The US Government brought a lawsuit against Citibank, which was settled for $158.3 million
Hunt received $31 Million (http://www.whistleblowerrecovery.com/citibank.html)

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Socially Responsible Investing

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Socially Responsible Investing
“The act of investing money with the deliberate intention

of achieving both financial value (return on capital) and social value (positive impact on social and environmental problems).” (Duke University CASE i3)
Other terms used: Sustainable and responsible investing, ethical investing
Related terms: impact investing (focuses on investment in privately owned entities and non-profits by individuals, governments and foundations)

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The Promise
“Who says you can't invest responsibly and still beat the

S&P 500? Now You Don't Have To Choose Between Your Financial Goals And Our Planet's Future – The myth about environmentally and socially responsible investing is that as an investor, you have to give something up—investment quality, portfolio diversification, or fund performance. At Sierra Club Mutual Funds, we beg to differ. While you do your part to protect the planet for your children and for future generations, we do ours by seeking attractive investment opportunities in well-known companies that meet strict Sierra Club social and environmental guidelines.” (Advertisement)

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US SRI Trends
December 2011: $3.31 trillion in US-domiciled assets
Approximately 1 in

every 9 dollars invested
30% increase since December 2009

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UK SRI Trends
June 2013: £12.2 billion
11.7% growth since Dec 2011
(http://www.eiris.org/)

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Investment Decisions
Generally involves applying environmental, social and governance (ESG) criteria to

investment analysis and portfolio selection
Five principle methods, which can be combined:

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SRI Products and Services
Indeces: Dow Jones Sustainability Indices (DJSI), FTSE4Good
Mutual

Funds: Calvert, Pax
Rating and screening: MSCI KLD (Morgan Stanley), ASSET4 (Thomson Reuters),
Performance: Studies show a variety of outcomes. Many funds’ performance matches S&P 500

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Dow Jones Sustainability Index
‘Best-in-class’ approach
Companies accepted into index chosen along following

criteria:
Environmental (ecological) sustainability
Economic sustainability
Social sustainability
Criticisms of index:
Depends on data provided by the corporation itself
Questionable criteria used by index
Focuses on management processes rather than on the actual impact of the company or its products

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Shanghai Stock Exchange
Introduced CSR Index in August 2010
100 firms with highest

ESG rankings
What was the performance of the CSR Index relative to the SSE180?

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SSE CSR Index Performance
5 August 2010 = 100

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Top 10 stocks held in SRI funds in emerging market firms,

2012

Source: Eiris, 2012

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Criticisms of SRI
Quality of information
Dubious criteria
Too inclusive
Strong emphasis on returns

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Principles of Responsible Investing
Developed by the United Nations
One of several

frameworks that propose to integrate ESG criteria into investment decisions

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Principles of Responsible Investing
We will incorporate ESG issues into investment analysis

and decision-making processes.
We will be active owners and incorporate ESG issues into our ownership policies and practices.
We will seek appropriate disclosure on ESG issues by the entities in which we invest.
We will promote acceptance and implementation of the Principles within the investment industry.
We will work together to enhance our effectiveness in implementing the Principles.
We will each report on our activities and progress towards implementing the Principles.

https://www.unpri.org/about/the-six-principles

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Islamic Finance
Based on the ethical principles of Islam
Rapidly growing industry
The stated

primary objectives are:
Equal distribution of wealth
Social justice
Similarities to traditional finance: The aims are successful financial intermediation and making a profit

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Islamic Finance
Key differences:
Interest prohibited
No financing of “sinful” activities such as alcohol,

gambling and pornography
Requirement for profit, equity and risk sharing
Prohibition on speculation
Financial products must be backed by tangible assets

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Shareholder Activism

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Shareholder Activism
Shareholder attempts to exert greater control over corporate decision making

and actions by exercising their legal rights
Two routes, often combined:
1. Shareholder proposals
In the US, can be introduced by any shareholder who held over $2000 in shares during the preceding year
Added to the corporate proxy statement and voted on by all shareholders
Often non-binding but disregard can be problematic for management
2. Speaking out at the annual shareholder meeting

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Shareholder Activism Examples
JP Morgan 2012 Proxy Statement contained 7 shareholder proposals:

Proposal 4 — Political non-partisanship. Famous activist Evelyn Y. Davis asked for political neutrality to avoid entanglements with certain political parties which could become detrimental to its business.
Proposal 5 — Independent director as chairman. Federal and State employees organization AFSCME Pension Plan addressed the fact that CEO James Dimon also serves as chairman of the Company’s board of directors. This combination of roles has the possibility of harming a corporation’s governance policies.
Proposal 6 — Loan servicing. The Board of Pensions of the Presbyterian Church requested the Board of Directors to oversee development and enforcement of policies to ensure that loans that are in default or foreseeable default are adequately modified. In other words, it asked JP Morgan to make an attempt to help those that have defaulted due to their own poor lending practices.
Proposal 8 — Genocide-free investing. Mr. William L. Rosenfeld asked the company to avoid investments in companies who are connected to genocide.

www.triplepundit.com

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Shareholder Activism Examples
McDonald’s 2013 Proxy Statement contained a shareholder proposal that

sought to prevent the company from marketing its fast food products to children given the serious impact that fast food has on public health.
Such resolutions typically garner 6-8% of votes

www.triplepundit.com

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Shareholder Activism Trends
http://www.proxymonitor.org

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Shareholder Activism Trends
http://www.proxymonitor.org
Only 7 percent of shareholder proposals received the backing

of a majority of shareholders in 2013, down from 9 percent in 2012

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Shareholder Activism Impact
“An analysis of around 2,000 interventions in America during

1994-2007 found not only that the share prices and operating performance of the firms involved improved over the five years after the intervention, but also that the improvement was greatest towards the end of the five-year period. The firms activists targeted tended to be underperforming relative to their industry. These results hold true for the two sorts of activism that tend to be criticised most: actions designed to increase a firm’s leverage, such as taking on more debt or using cash to buy back shares, and actions that are especially hostile to a firm’s current management.” (Economist, 2014)
Sends signals to management, even if it doesn’t pass

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Conclusion
Divergent interests between shareholders and managers and information asymmetry can create

ethical problems that hurt shareholder value.
We assume that shareholders only want financial return, but the emergence of shareholder activism and SRI show that a growing number of shareholders are concerned with ethics and governance issues.
SRI is growing and slowly becoming mainstream. These are helping to make firms aware of ethical issues and CSR.
Islamic finance is another growing phenomenon indicating that many investors are concerned with more than only profits.

Shareholders and Business Ethics

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