The perils of the ‘business case’

Published December 14, 2013

First published in Business Times on 12 December 2013

Mak Yuen Teen


business case

Look further ahead: Corporate governance is about enhancing long-term shareholder value; and embracing sustainability, diversity and ethical behaviour is likely to help companies achieve that. Fixation with the short-term ‘business case’ runs counter to good corporate governance. – PHOTO: REUTERS

LAST year, someone who is active in the sustainability area in Singapore shared with me that many companies are engaging in sustainability initiatives only because they expect to see these being translated into profits.


A senior executive of a listed company also asked me if research has shown that companies with better sustainability reporting had better financial performance, saying the board and management needed to be convinced about the “business case” for sustainability.


At the recent Global Corporate Governance Conference organised by the Securities Investors Association (Singapore) held here, a major global fund manager said that their valuation model shows that companies which do better on sustainability have better valuations, and that this helps them to convince their investee companies to invest in sustainability initiatives.


I asked him what he would tell his investee companies if this relationship between sustainability and valuation disappeared. He basically said that evidence supporting the “business case” was important to sustain the sustainability agenda.


It seems that many companies are not prepared to do the right thing just because it’s the right thing to do; rather, they expect to see a clear boost to their profitability or share price. Even if we use forward-looking valuation- based measures such as price-to- earnings, markets may not be so efficient as to price in the future net benefits of sustainability initiatives that companies are undertaking or discount those which behave irresponsibly.


Did the markets price in the ethical, risk management and corporate governance weaknesses of the many financial institutions which subsequently collapsed during the global financial crisis, or those of companies caught in scandals involving financial irregularities, corruption, money- laundering, and environmental disasters? Obviously not. Many of these problems took years to unravel but ultimately had a devastating effect on the value and reputation of companies.


There has been a pushback against the shareholder value model after the global financial crisis. A laser-like focus on short-term share price performance and other financial metrics is widely thought to have caused companies to ignore other factors which are important for the creation of long-term value of the company to shareholders and other stakeholders.


Yet ironically, the benefits of sustainability are being evaluated using those very metrics which have been criticised.


A corporate social responsibility (CSR) consultant was recently quoted as saying that CSR should be linked to profits in the minds of boards of directors. I would suggest this link is easier to imagine than to establish. Companies may be better off taking a leaf out of Johnson & Johnson’s Credo developed in 1943 – which put customers, suppliers, distributors, employees and the community first, with shareholders expected to get a fair return on a sustainable basis if they look after these other stakeholders well.


Our regulators have been making the right noises to encourage companies to think beyond short-term financial performance and shareholder value. The revised Code of Corporate Governance (2012) made three changes which point boards to incorporate ethical, sustainability and broader stakeholder considerations into their decision making.


First, it urged boards to “identify the key stakeholder groups and recognise that their perceptions affect the company’s reputation”. Second, boards are asked to “consider sustainability issues – for example, environmental and social factors – as part of its strategic formulation”. Third, it clarified that in setting the company’s values and standards, it should also include ethical standards. In 2011, the Singapore Exchange (SGX) also issued the Guide to Sustainability Reporting for Listed Companies.


Unfortunately, such initiatives will not gain traction if companies expect to see the “business case” in the form of clear financial payoffs from behaving ethically or incorporating sustainability or wider stakeholder considerations into their decisions.


The fixation with the “business case” also afflicts other corporate governance debates, such as the debate about gender diversity on boards. Advocates of gender diversity often cite studies showing correlations between gender diversity and financial performance. These studies fail to control for many factors and to establish causality. In November 2012, the Conference Board in the US, after reviewing studies on the subject, concluded with this rather tentative statement: “When viewed in totality, the empirical results provide at least some support for the proposition that board diversity may lead to increased firm value or improved corporate governance under certain conditions.”


The low representation of women on our boards hinders board effectiveness. The logic ought to be simple: if boards matter, then getting the right people on them matters; and failing to tap the substantial pool of qualified women – who, on average, bring different skills, traits and perspectives – must be harmful for companies in the long run.


If a company recruits directors on an ad hoc basis based purely on personal connections and networks – which many surveys suggest to be the case in many Singapore and Asian companies – rather than through a proper search and nomination process, women who are appointed may not be the most suitable candidates and may not bring those different skills, traits and perspectives that make them valuable on boards.


Let us also not forget that while research shows that there are general differences between males and females in terms of leadership, decision-making and behavioural traits, these differences are based on the “average” male and the “average” female. It is arguably not gender per se that matters, but the attributes which generally differentiate the genders which make gender diversity important.


However, even if appropriate female candidates are appointed, we cannot necessarily expect the company’s profitability or share price to improve, especially in the short term. If having more women on boards leads to better risk management and corporate governance, better understanding of customers’ preferences, more balanced employment policies or more equitable “pay for performance” within companies, these may not necessarily translate into improved profitability or valuations in the short term. This does not mean that gender diversity does not matter for the longer-term well-being of companies.


Studies which focus on correlations between gender diversity on boards and company financial performance, in addition to being statistically and philosophically flawed, ignore the multifaceted nature of the board’s role. The Code of Corporate Governance makes it clear that the board’s role is not just about (or even primarily about) increasing profitability or share price. It includes, for example, ensuring that there are proper internal controls and risk management systems in place to prevent management from recklessly taking on risks to increase short-term profitability or stock price.


If we ask boards whether their effectiveness should be evaluated primarily on financial metrics such as return on equity or stock price performance – the very metrics used by studies on gender diversity and financial performance – I would be very surprised if many boards believed so. This is not to say that the board should not be responsible for ensuring that the company performs well financially, but the board’s role extends well beyond delivering financial performance.


Doing the right thing because it is the right thing to do is likely to pay off – but not in the short term. Corporate governance is about enhancing long- term shareholder value; and embracing sustainability, diversity and ethical behaviour is likely to help companies achieve that. Fixation with the short-term “business case” runs counter to good corporate governance.


One of my favourite quotes on ethics is by Peter Forstmoser, former chairman of Swiss Re, who said: “To be ethical is profitable, but to be ethical because it is profitable is not ethical. And, one might add, it is also not profitable in the long run.”


Companies which are constantly looking for the “business case” to do good would do well to heed this quote. Or as Albert Einstein was quoted as saying: “Not everything that counts can be counted, and not everything that can be counted counts.”


The writer is an associate professor of accounting in NUS Business School, where he teaches corporate governance and ethics


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