Sunday, December 13, 2020
This is my second post in a series of blog posts on the "Study on Directors' Duties and Sustainable Corporate Governance ("Study on Directors' Duties") prepared by Ernst & Young for the European Commission.
In 2015, the world gathered at the United Nations Sustainable Development Summit for the adoption of the Post-2015 development agenda. That Summit was convened as a high-level plenary meeting of the United Nations General Assembly. At this meeting, Resolution A/70/L.1, Transforming our World: The 2030 Agenda for Sustainable Development, was adopted by the General Assembly. In 2016, the Paris Agreement was signed. In my last post, I called both the United Nations 2030 Agenda and the Paris Agreement trendsetters because they kicked-off a global discussion on sustainable development at so many levels, including at the financial level.
During the 2015 United Nations Sustainable Development Summit, I recall that the Civil Society representatives called for a UN resolution on sustainable capital markets to tackle the absence of concrete actions regarding global financial sustainability following the 2008 Great Recession.
At the end of 2016, the European Commission (Commission) created the High-Level Expert Group on Sustainable Finance (HLEG). In early 2018, the HLEG published its report. Shortly after, in 2018, the European Union (EU) published the Action Plan: Financing Sustainable Growth (EU's Action Plan) based on the HLEG’s report. I want to focus for a bit on Action 10 of the EU's Action Plan: Fostering Sustainable Corporate Governance and Attenuating Short-Termism in Capital Markets. Action 10 sets forth the following:
1.To promote corporate governance that is more conducive to sustainable investments, by Q2 2019, the Commission will carry out analytical and consultative work with relevant stakeholders to assess: (i) the possible need to require corporate boards to develop and disclose a sustainability strategy, including appropriate due diligence throughout the supply chain, and measurable sustainability targets; and (ii) the possible need to clarify the rules according to which directors are expected to act in the company's long-term interest.
2.The Commission invites the ESAs to collect evidence of undue short-term pressure from capital markets on corporations and consider, if necessary, further steps based on such evidence by Q1 2019. More specifically, the Commission invites ESMA to collect information on undue short-termism in capital markets, including: (i) portfolio turnover and equity holding periods by asset managers; (ii) whether there are any practices in capital markets that generate undue short-term pressure in the real economy.
Under the EU's Action Plan, in 2019, the Commission called the three European Supervisory Authorities (ESAs) to collect evidence of undue short-term pressure from the financial sector on corporations. These supervisory authorities include the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pension Authority (EIOPA). The reports from EBA, ESMA, and EIOPA reviewed the relevant financial literature and identified potential short-term pressures on corporations.
In 2019, the European Commission Directorate-General Justice and Consumers organized a conference on "Sustainable Corporate Governance" that reunited policy-makers to discuss policy developments on corporate governance within Action 10 of the EU's Action Plan.
The Study on Directors' Duties builds on Action 10. As it reads in the Study:
[T]he need for urgent action to attenuate short-termism and promote sustainable corporate governance is clearly identified in the Action Plan on Financing Sustainable Growth, 137 put forward by the European Commission in 2018. The Action Plan recognises that, despite the efforts made by several European companies, pressures from capital markets lead company directors and executives to fail to consider long-term sustainability risks and opportunities and be overly focused on short-term financial performance. Action 10 of the Action Plan is therefore aimed at "fostering sustainable corporate governance and attenuating short-termism in capital markets." The present study implements Action 10, together with other studies aimed at investigating complementary aspects of short-termism,138 which shows European Commission's commitment to explore this complex problem from different angles and find an integrated response.
Before moving forward, it is pressing to define short-termism. In this context, obtaining empirical evidence to infer causation is important for policy advice. When it comes to defining short-termism, in a recent Policy Workshop on Directors' Duties and Sustainable Corporate Governance, Zach Sautner defined short-termism as a reflection of actions (e.g., investment, payouts) that focus on short-term gains at the expense of the long-term value of the corporation. The concept of short-termism encompasses a certain form of value destruction, an undue focus on short-term earnings or stock price, and a notion of market inefficiency. Suppose a CEO favors short-term earnings or makes decisions (e.g., buybacks) to the detriment of the corporation's long-term value. Then, if the market is efficient, it should signal that something is not right.
Still, I cannot avoid asking: is short-termism the right problem that needs fixing? The discussion around short-termism is puzzling because there is a vehement academic debate whether there even exists short-termism or whether it is as harmful as it sounds. For example, in their paper, Long-Term Bias, Michal Barzuza & Eric Talley explain how corporate managers can become hostages of long-term bias, which can be as damaging for investors as short-termism.
If short-termism and its effects are as negative as they sound, what kind of incentives do managers have to overcome it? Corporate managers act based on incentives such as executive compensation, financial reporting, and shareholders' ownership. Is this bad news for those who firmly stand behind stakeholders who can be undoubtedly impacted by the corporation's performance?
The bottom line is this. We need a clearer perspective on short-termism. Suppose one says that excessive payouts are not the problem. They are the symptom. However, even this bold statement needs to be taken with a grain of salt. It is difficult to assess if payouts (e.g., dividends, buybacks) are excessive if we do not know if there is a short-termism problem.