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Corporate Law and Social Risk

Posted by on Monday, October 19, 2020 in Articles, Volume 73, Volume 73, Number 5.

Over a quarter of total assets under management are now invested in socially responsible companies. This turn to sustainability has gained solid ground over the last few years, earning the commitment of hundreds of CEOs and dominating the global business agenda. This marks an astounding repudiation of Wall Street’s get-rich-quick mentality, as well as a direct challenge to corporate law’s reigning mantra of profit maximization above all. But corporate law scholars are skeptical about the rise of sustainability. Some scoff at companies’ promises to “do the right thing” as empty rhetoric. But companies are revisiting core business practices and adjusting central governance mechanisms, such as executive compensation, to reward improvements in sustainability performance. For other theorists, directors and officers beholden to shareholder primacy can opt for sustainability only as long as it also maximizes profits. While doctrinally straightforward, this approach is highly problematic in practice. The wide range of issues nurtured under the sustainability movement—ranging from environment and climate, to diversity and other workplace concerns, to privacy and supply chain management—do not always lend themselves readily to a profit-maximizing logic and are often costly in the short term.

We offer a new solution to this quandary. We argue that, through their sustainability initiatives, companies are looking primarily for safeguards against downside risks, and not simply for opportunities to increase their profits. Social risk has proven highly destructive for corporate value even when the company’s key failure is not violating laws, as the recent crises at Facebook and Uber demonstrate. Sustainability can help avoid such crises because it provides corporate boards with input from stakeholders such as employees, NGOs, local authorities, and regulatory agencies. These stakeholders are uniquely placed to register the impact of company policies on the ground and can communicate concerns early. Contrasting sustainability with compliance, the only risk monitoring mechanism sanctioned in our laws, we note distinct advantages. While compliance’s scope is tethered to legal violations, sustainability encourages intervention even when laws have not caught up. Compliance’s emphasis on detection and punishment distorts management’s incentives and incites fears of retribution in stakeholders. Rather than dwelling on the past, sustainability builds a new vision for the future hoping to inspire and gain trust.

We base our account of sustainability on interviews and roundtable discussions with over three hundred participants, including leading public and private companies, large asset managers, investors and pension funds, shareholder advisory firms, and sustainability standard setters and data providers. Our conversations confirm that it was investors who pushed hard for environmental and social initiatives, putting pressure on more reserved managers and boards. We argue that investors’ support for sustainability is precisely because it helps fight risks that are otherwise hard to diversify. Asset managers, in particular, who own significant positions in every U.S. public company, are exposed to industry-wide and market-wide risk and may suffer externalities from a company’s reckless behavior.

While investors have been early supporters, CEOs and executives are only recently opening up to sustainability, which continues to face some resistance in corporate boardrooms. We argue that directors’ and officers’ unwillingness to address social risk is a manifestation of agency conflicts. Averting crises is a thankless task, and boards have few incentives to undertake action without external pressure. Moreover, the intractability of many sustainability concerns, combined with management’s confidence in the company’s success, leads to systematically downplaying social risk. But by failing to establish an appropriate sustainability function, directors and managers are unnecessarily exposing their shareholders to increased risk. Boards should ensure that their company has a well-running sustainability function with proper board oversight that reaches out to stakeholders relevant to the company’s business. This governance reform, we conclude, is essential to allow sustainability to reach its full potential.

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Stavros Gadinis and Amelia Miazad