The Best Paper of the latest Corporate Governance Paper Competition held by The Hong Kong Chartered Governance Institute (the Institute) looks at the challenges involved in tying governance to a sense of corporate purpose that takes into account multiple stakeholder interests.
The Institute holds its annual Corporate Governance Paper Competition and Presentation Awards to promote awareness of corporate governance among local undergraduates. This article is a summary of the Best Paper of the 2021 Corporate Governance Paper Competition. In this first part of the paper, the authors discuss the incentives to exercising purposeful governance from three perspectives – profitability, sustainability and ethics.
The possibility of corporations pursuing purposes other than profit has been the subject of debate for several years, with two competing theories: shareholder theory and stakeholder theory. The stakeholder theory recognises the responsibilities of corporations in the world today, whether they be economic, legal, ethical or even philanthropic. Numerous multinational companies claim to have corporate social responsibility (CSR) at the centre of their corporate strategy.
The current Covid-19 pandemic has led to a market downturn and has constrained investor enthusiasm for investment. To reheat the market and rekindle investor sentiment, corporations are now compelled to perform comprehensive and intelligent governance and trade-offs.
Corporate governance was originally defined as ‘the system by which companies are directed and controlled’. Corporate governance is now coming to prominence in the business world, based on contributions from professionals and academics. Its theories are based on several disciplines: finance, economics, accounting, law, management and organisational behaviour. Some prominent fundamental theories have been developed to demonstrate corporate governance and the relationship among the parties connected to companies, notably agency theory, stewardship theory, stakeholder theory, resource dependency theory, transaction cost theory and political theory. More importantly, two mainstream theories have drawn the attention of scholars: shareholder theory and stakeholder theory.
Shareholder theory, the original theory of corporate governance, primarily focuses on agency theory. Under this theory, corporate governance aims to eliminate or minimise conflicts of interest between shareholders and directors, and to maintain investor optimism in the long run. Also, it is essential to figure out effective ways of monitoring management teams’ actions for the companies. In other words, the board of directors must manage the corporation’s business on behalf of the shareholders.
However, this theory does not put any emphasis on the interests of external stakeholders, such as the community or the environment. Shareholder theory is often understood to preclude companies from considering CSR in the decision-making process. Milton Friedman, who first advanced shareholder theory, claimed that the social responsibility of businesses is to increase profits. From Friedman’s point of view, a business should seek profits as its aim, rather than CSR, because it reduces the conflicts of interest among employees, shareholders and the board of directors. Hence, the shareholder theory emphasises profits only.
With the development of corporate governance, stakeholder theory has become one of the mainstream theories. Stakeholder theory is significantly different from shareholder theory, as it explicitly addresses morals and values as central features of organisational management. In comparison with shareholder theory, stakeholder theory emphasises the needs of stakeholders, and thus concerns the needs of every group who can affect and/or can be affected by the companies’ decisions. In line with this, Richard Branson and Simon Sinek concluded that companies should emphasise purposes and values created beyond profit, suggesting that companies should create value to benefit their internal and external stakeholders, rather than simply making profits for shareholders.
The stakeholder approach considers fundamental stakeholders to include customers, shareholders, investors, employees, suppliers, the government, communities and the environment (see ‘Stakeholders’ interests diagram’). The stakeholder approach is more appropriate for the business world of the 21st century as it considers society as a whole.
We will now turn to the incentives to exercising purposeful governance from three perspectives – profitability, sustainability and ethics.
Profitability, as a likely result of purposeful governance, nurtures the growth of the company. It can motivate companies to further improve their ethical corporate governance and thereby form a virtuous cycle.
One study, conducted by scholars from the University of California in 2011, shed light on the positive correlation between stakeholder relationship management and return on assets (ROA), which serves as an indicator of profitability. The Kinder, Lydenberg, Domini & Co (KLD) database was employed, providing data on corporate social performance and different stakeholder relationships. Referring to the research, five key measures were selected: employee relations, product safety/quality, diversity, environment and community. By conducting regression analysis on the statistics, the result reveals that employee relations and product safety/quality are the most significant among the five measures. The result verifies the hypothesis that stakeholder relationship management in corporate governance positively impacts financial performance.
Other relationships with stakeholders also influence the performance of the company. For instance, one study found a positive correlation between a corporate governance mechanism that prioritises the interests of alliance partners and the associated gains. This stakeholder orientation increases the loyalty and commitment to the alliance, eventually pursuing the maximisation of shareholder interests. Concerning the environmental perspective, another study revealed the positive effect of environmental CSR on corporate profitability. CSR refers to a range of company activities focusing on stakeholder welfare, where the environment is one of its stakeholder groups. Benefits of implementing CSR, where the environment is taken into consideration, include improved brand reputation and consumer purchase intention, driving the consumers to purchase environment-friendly products. At the same time, customers are more willing to pay higher prices, offsetting the increased costs incurred of CSR practices. As a result of the higher quantity and higher price, environmental consideration impacts positively on corporate profitability.
Analysing the above studies, a well-governed company based on a stakeholder perspective results in an improved financial performance. This is also in line with the instrumental stakeholder theory, which asserts that a firm with stakeholder management will have better profitability, growth, stability and other aspects. In other words, this is the expected return, which is why taking a stakeholder perspective is considered necessary. The expected profitability pushes the firm to improve corporate governance from a stakeholder standpoint, providing possibilities of purposeful management given a myriad of stakeholders’ views.
More importantly, sustainability can be achieved through purposeful governance with a stakeholder perspective. There are two types of sustainability: organisational sustainability and global sustainability.
Organisational sustainability. Not only does the stakeholder approach accelerate profitability, which can be quantified, but it also benefits the company in ways that are unquantifiable, such as an improved public image, increased investor confidence, easier employee recruitment and so on. These intangibles contribute to the firm’s self-interest in the long run through the achievement of social power. In terms of the workforce, for example, favourable policies and promoted welfare towards its employees will result in a recognition of the company as being employee-orientated and having corporate citizenship. Employee engagement will likely be improved and trust will be built, supporting the organisation’s sustainability.
Global sustainability. Global sustainability goes beyond organisational sustainability and includes the interests of the natural environment and future generations. The World Commission on Environment and Development defines sustainable global development as ‘satisfying the present need without compromising the ability of future generations to satisfy their needs’, which is from the perspective of a relatively longer timeframe and a broader range of parties.
Global sustainability can be achieved when taking account of the interests of future generations from the basis of organisational sustainability. For example, the concept of the environment’s ‘carrying capacity’ was proposed for the aviation sector, the purpose of which is to stipulate the respective usage rates of renewable and non-renewable resources, as well as the rate of pollution emissions for sustainable airport development. The consideration for the natural environment and future generations in corporate governance prompts the achievement of global sustainability, becoming an advantage and giving the possibility of stakeholder orientation.
3. Ethical considerations
Moreover, there are currently three prominent stakeholder theories: normative stakeholder theory, instrumental stakeholder theory and convergent stakeholder theory.
Normative stakeholder theory states that moral and normative commitments should be the core motivating factors behind the decision-making process. The theory has two main elements: denying the separation fallacy and its usefulness in corporate governance, and recognising and maximising the intrinsic value of stakeholders. In this regard, it can be considered as one kind of general movement, which provides powerful alternatives to the ‘dominant’ shareholder model. In other words, the normative stakeholder theory claims that all stakeholders have intrinsic moral value. People who support the normative stakeholder theory consider this approach to be just and fair to everyone.
The instrumental stakeholder theory focuses on the performance consequences of having a highly ethical relationship with stakeholders, characterised by a high level of trust, cooperation and information sharing. To illustrate, an increase in efficiency and effectiveness of operations, better performance in terms of financial position and, ultimately, higher profits are the goals of this approach. Hence, the proponents of instrumental stakeholder theory are the stakeholders who care about profit as their priority.
Scholars differ in opinion regarding these two emphases. A new theory was therefore developed, namely convergent stakeholder theory, as being ‘morally sound in its behavioural prescription and instrumentally viable in its economic outcomes’. As convergent stakeholder theory is both normative and instrumental, it has a strong basis in morality, which accepts that the basic intention behind specific aims should be to achieve an ethically acceptable outcome. From this perspective, the convergent stakeholder theory can be considered the best version of stakeholder theory as it combines ideas from both schools.
Creating shared value (CSV) is a familiar concept under the convergent stakeholder theory. However, CSV is slightly different from CSR. To illustrate, CSR is a cost centre to a business rather than a profit centre, from which cash flows out to other parties, such as NGOs. In addition, CSR only emphasises a company’s responsibility to the community, including such activities as donating to universities, reducing carbon footprint and improving labour policies.
In contrast, CSV does not concentrate on company responsibility, but rather on creating value with other stakeholders. To illustrate, CSV is a business model that will accelerate the achievement of sustainable development goals for the benefit of society as a whole. Referring to the scholars’ definition, CSV is comprised of strategies and policies that make companies more competitive, while simultaneously advancing the economic and social conditions in the communities in which they operate. The definition of CSV reveals that its goal is to create value to help the community.
To apply CSV in the real business world, one example is G for Good, a Hong Kong start-up and a subsidiary of New World Development Company Ltd (NWD). G for Good has two goals: building communities of social innovators to assist them in delivering CSV projects to the broader public and investing in potential social innovation companies with a CSV model. In only a few years, G for Good has successfully impacted the Hong Kong community, and in 2019 – its founding year – was a recipient of the Shared Value Awards, the first Hong Kong company to obtain this award.
In conclusion, CSV is also appropriate for a business to implement in the long run, as evidenced by the successful role of G for Good in building an excellent social image for NWD.
Shevin Fan, Isaac Lee, Hellen Liu and Magnolia Wang
City University of Hong Kong
More information relating to the Institute’s Corporate Governance Paper Competition and Presentation Awards was published in the Student News section of the November 2021 edition of this journal.