26 January 2022

Investors must address stakeholder issues in alignment with client interests and fiduciary duty 

During 2021, The Investor Forum and the Centre for Corporate Governance at London Business School collaborated on a year-long project to investigate the question: What does stakeholder capitalism mean for investors? The report can be found here.  This is the transcript of my talk at the Investor Forum Annual Review on 25th January 2022, presenting the key findings.

Introduction

The widespread loss of trust in shareholder value, and calls for move to a more stakeholder-oriented model, are undeniable. The seriousness of the claims demands a serious response, and that is certainly what this distinctive collaboration has aimed to provide. 

Our report is in three parts. In Part 1 we compare the shareholder and stakeholder models and seek to draw out key insights from this. In Part 2 we consider what action investors can take in response to these insights and to address the challenges that arise. In Part 3 we provide what we hope are useful frameworks for investment practitioners wanting to implement the ideas in our report. 

Part 1: Review, insights and challenges

So let’s start with Part 1. We start off by reviewing the charges laid against shareholder value. Pursuit of shareholder value is accused of leading to:

• Short-termism - to the detriment of companies’ long-term health; and to

• Stakeholder harm – to the detriment of wider society.

While the problems faced by society are real, the claim that shareholder value is their root cause is much less convincing. The idea that shareholder value is inherently short-term in nature just isn’t supported by the evidence. The value of a company, based on its prospects far into the future is an inherently long-term concept. 

Moreover, stakeholder value and shareholder value are aligned to a much greater degree than commonly assumed. Maintaining strong relationships with key stakeholders is a fundamental requirement for a company seeking to create shareholder value over the long term. So the gap between shareholder and stakeholder value is significantly closed if investors have a long-term orientation.

For sure, shareholder value can be implemented in a short-term and exploitative way, but, importantly, this is frequently to the long-term detriment of shareholders themselves. 

But there are misaligned incentives within the system which can lead to the misapplication of shareholder value – poorly constructed investment mandates and short-term executive pay are two such examples – and there are externalities and negative impacts that governments are not dealing with and where there are increasing calls for business, and as part of that investors, to play a bigger role. 

So we then to turn the alternative stakeholder models that are proposed to address these perceived problems with shareholder value. There is not a single stakeholder model that is uniformly promoted by all advocates of reform. Most proposals retain shareholders as the ultimate beneficiaries of the company’s activity. But the difference is that boards are given greater direction and discretion to increase the priority of the interests of other stakeholders versus shareholders – creating a so-called “zone of insulation” against shareholder pressure. This can be achieved either by changing the legal purpose of the company to emphasise multiple stakeholder rights - for example, the better business act, or b-corporations. Or it can be achieved by giving boards more leeway by reducing direct shareholder rights, for example, through staggered boards, takeover defences and so on. 

This greater leeway could be used to pursue long-term objectives that increase shareholder value and simultaneously benefit stakeholders. This is a clear win-win.  However, that’s the easy case.  The challenge is how to deal with more complex situations where shareholders suffer costs but there is arguably a net societal gain.  Or, greater board freedom may also result in lack of accountability, with companies coasting, resources being wasted and special interests becoming entrenched, resulting in a net loss to society.

Which of these outcomes dominates is an empirical question. And overall, the evidence is not favourable to the more stakeholder-oriented models. The costs to shareholders in terms of reduced value are clearly identifiable and the benefits to stakeholders are highly uncertain and difficult to demonstrate. 

This isn’t to say that these alternative governance models are never beneficial. Indeed the evidence shows that in some situations they are, even for shareholders. And we see shareholders in certain cases supporting them, as was famously the case with Danone’s conversion to an enterprise à mission in 2020. However, a model sometimes working is not the same as it always working. 

Overall the evidence suggests these adaptations to the shareholder value model are unlikely unleash better business performance and social outcomes. So rather than arguing over the details of corporate governance models, we argue it is better to focus on how we can make the system we have work better.

But let me be clear that this finding does not let investors off the hook.  The investor community simply cannot afford to be complacent. The pressure to take far greater account of stakeholder concerns will be unrelenting. It is also the case that, in many cases, investment processes remain too divorced from the stakeholder context within which business operates today. 

The challenge is therefore to identify a principled and rigorous way that investors can respond to these stakeholder concerns, in a manner that is fully consistent with their fiduciary duties to clients.

Part 2: Practical actions

In Part 2 we go back to first principles on the components of a sustainable shareholder value model to look at where the areas of focus need to be.

There are many aspects of this model that will seem like motherhood and apple pie, so I just want to focus on some points where we believe that significant improvements can be made. 

First of all, the whole societal context for business is changing. The intangible nature of business, the level of transparency, and the speed of information flows all mean that investors need to be more attuned than ever before to the societal and stakeholder context within which they are operating. So investors need to do more work to incorporate stakeholder perspectives into their investment process. 

Second, the only source of legitimacy for investor action comes from client mandates and fiduciary duty. Yet client mandates are often technical documents that don’t well explain how clients should expect investors to act on stakeholder issues. The risk then is that the asset manager’s own priorities take over. So we argue that there needs to be a significant step change in mandates to create a shared understanding of how these stakeholder issues will be taken into account. This will include tough conversations (or for retail or pooled funds clear disclosures) about the extent to which clients may in some cases need to accept lower long-term returns in order to meet their preferences on a particular stakeholder issue.

Third, the way in which stakeholder issues make their way into the decision-making process can seem chaotic at times. Interest groups take advantage of societal concerns to push a particular agenda, and the loudest and most effective campaigners win. Investor governance departments then promote a range of issues that appear to companies on the receiving end to be uninformed and disconnected from business priorities or the investment thesis. So investors need to get much better at prioritising, and articulating why they are prioritising, stakeholder issues. 

Now if investors are going to explain to clients and the companies in which they invest why they are acting on certain issues and not others, they need a clear decision-making framework. 

So what would such a framework look like?

Principles for action on stakeholder issues

We have developed a triple test of three principles against which investors should determine whether to act on a stakeholder issue.

1.     Materiality

The first principle is materiality. In order for investors to have a mandate for action on a stakeholder issue, the stakeholder should be material. 

The most straightforward case is where addressing the stakeholder issue also adds shareholder value. For example, it has been shown that treating employees well leads to better long-term performance. In this case, investors seeking action from an investee company on the issue of employee welfare are directly fulfilling their mandate to enhance shareholder returns. This is the simple case of a stakeholder that is financially material to the company. 

But materiality has moved on beyond this. If a company has significant impact on a stakeholder (so-called Impact Materiality) there may be reason to take action even if the stakeholder currently has no financial impact on the company. 

One reason is the dynamic nature of materiality. A company that has a large negative impact on a stakeholder may well find that at some point the same stakeholder becomes financially material to the company. Carbon emissions are a great example of where companies have had a material impact on the environment for a long time, but only recently has this impact translated into a material financial issue for the companies themselves as a result of a combination of increased scientific knowledge, changing consumer attitudes and evolving economic and regulatory pathways towards net zero.

Another reason for action could be intrinsic motivations for prioritising the stakeholder’s interests. For example, clients may have non-financial goals and preferences for how their portfolio is managed regardless of whether that reduces returns, or the issue may reflect a desirable minimum standard on a societal basis – for example human rights standards. 

Materiality is a complex and abused concept and one of the useful contributions I think we have made in this report is to develop a comprehensive framework that systematically integrates the various perspectives on materiality that have emerged in recent years, which we hope investors will find useful when deciding which stakeholder issues warrant their attention.

2.     Efficacy

The second principle is efficacy. There should be a realistic prospect of investor action bringing about change in the real world.  Investors only have indirect impact through the influence they have on investee company actions. For this reason, the influence investors can have on real-world outcomes is often less than claimed.

One of the risks in relation to green-washing is investors claiming credit for real-world impact that cannot be justified by the evidence. Integrity relating to claims for real-world impacts will be an important part of trustworthy stakeholder-oriented behaviour by the investment industry. 

3.     Comparative advantage

Finally, we have the principle of comparative advantage. Investors should act where they are well-placed to address the issue, either individually or collectively, and when compared with other actors, for example government or stakeholders themselves. 

Just because an issue is important does not mean that everyone should act upon it. This links to the concept of fiduciary duty. Investors are increasingly under pressure from a range of interest groups to use their powers in support of particular stakeholder issues. But just because investors can act on an issue does not mean they should. Investors need to consider whether they are indeed the most appropriate party to act on a given issue. 

The list of so-called “systemic issues” on which investors are urged to act has grown to include climate change, inequality, human rights, diversity, deforestation, biodiversity, antimicrobial resistance, artificial intelligence, and fair distribution of COVID-19 vaccines. While these issues are all important, not all of them have systemic valuation impacts across the market that can usefully be addressed by investors. We either need to admit that some of these objectives are being pursued for non-financial reasons, and get the clear mandate from clients to do that, or recognise that there may be other parties than investors better placed to pursue them, in particular government.  

Political legitimacy

This brings me onto the topic of political legitimacy. In a number of stakeholder areas there is significant risk of investors being drawn into promoting activity that is fundamentally political in nature. Everybody wants their issue to be prioritised. But one person’s essential priority is another person’s grave error.  Although investors’ clients are drawn from across society, on a vote-weighted basis they are not politically representative. There is risk of investor action on stakeholder issues decreasing, rather than increasing, trust if it is seen to be a way that an elite formed of investors’ most valuable client segments, can use their financial firepower to bypass the political process. 

So investors need to be thoughtful about getting too far ahead of political consensus on the stakeholder issues they act on. Of course, the role of investor (and broader business) leadership is relevant here. Business can play a role in influencing societal attitudes, as well as responding to them. This has arguably happened in relation to climate change where investor and corporate action on the issue has made it easier for government itself to act. But it is a delicate balance. I think an underemphasised area is the role investors can play to support and maintain the robust institutions and regulation essential to the functioning of capitalism, through influencing responsible corporate lobbying activity, tax policies and so on. This is less politically fraught, although even here one person’s enabling regulation is another’s overweening interference of the state.

Next steps

We finish the report with a number of suggestions to support practical action within the investor community. These include pursuing work on improved model mandates, creating horizon scanning capability for addressing stakeholder issues, looking at what should reasonably be expected of boards in relation to stakeholder impact assessments, and developing the stakeholder prioritisation and materiality frameworks we develop in this report. 

Conclusions

To summarise, while the problems faced by society are real, the identification of shareholder value as their root cause is less convincing. 

Stakeholder-oriented models, risk reducing accountability of management, without showing clear benefits for society.

So rather than framing the debate as a choice between different models, our assertion is that we need to look at the practical actions investors can take to support sustainable shareholder value creation. It is this, in any event, that is within the control of investors. 

We conclude that more work is needed on 

• incorporating stakeholder considerations into the investment process, which may include improved horizon scanning

• developing mandates to lift them from narrow contractual commitments to becoming agreements that create shared expectations on how investors will act on stakeholder issues

• and on clearly and rigorously prioritizing the stakeholder issues on which investors choose to act.

In this report we provide investors with some of the tools needed to do this work.

The investor community, we conclude, has a legitimate role in addressing stakeholder issues, both within individual companies and when dealing with market-wide, systemic risk. Moreover, we argue that this can be achieved without compromising client interests and fiduciary duty. This, in our view, is exactly what stakeholder capitalism means for investors. However, investors need to be extremely clear on their mandate for pursuing such issues and on the likely overall effectiveness of their actions. 

This is a major undertaking. But only on this foundation will investors have a sound basis for determining how they will reconcile responsiveness to stakeholder issues with adherence to fiduciary duty. And through that process create the circumstances for shareholder value to be seen as part of the solution rather than part of the problem.