What’s the Appropriate Role of Governance in Spurring System Value Creation? Or: Why Strategic Duty Requires a Shift from Governance Push to Pull Governance

By Bill Baue & Ralph Thurm

The latest “shot heard ‘round the world” has been fired! But as with the first gunshots of the Revolutionary War and World War I, there’s a lag time between the actual event, and widespread recognition of its significance. The most recent shot, aimed squarely at the heart of unsustainable quarterly capitalism, was fired by Keith Johnson and Kenneth McNeil (with gunpowder provided by Mark Van Clieaf of Organizational Capital Partners, a member of the Reporting 3.0 New Business Models BlueprintWorking Group). Johnson recently posted the incendiary article, “The Elephant in the Room: Helping Delaware Courts Develop Law to End Systemic Short-Term Bias in Corporate Decision Making,” which is forthcoming as the lead article in Michigan Business & Entrepreneurial Law.

The piece makes the case that corporate pursuit of short-term profits has eclipsed sustainable long-term value creation, despite the fact that the latter is the rightful core of fiduciary duty. Johnson & McNeil further observe that “Delaware court justices, the primary referee of corporate director fiduciary duties in the United States, are so frustrated with the persistent effects of short-term pressures … that they are actively encouraging investors to bring the right cases to help change the rules.”

Bang!

This strategy aligns precisely with Reporting 3.0’s line of advocacy, which similarly seeks systemic solutions (i.e. corporate and institutional investment governance focused on sustainable long-term value creation) to what the piece refers to as “systemic failures” (i.e. such governance focused on unsustainable short-termism).

What’s the issue?

Johnson & McNeil open with stunning statistics:

  • According to McKinsey, 85% of the 384 companies it surveyed have strategic planning horizons of less than 5 years; yet corporations that do long-term planning had economic profits 81% higher between 2001 and 2014 — with less volatility — than other firms.
  • According to Van Clieaf et al, “[a]t least 50% of the current value of the top 1500 S&P corporations is ‘future value.’ And the trend toward a future value as a higher percentage of total equity value is growing.” However, “85% of the S&P 1500 have long term incentive plan performance periods of 3 years or less.”
Figure 1: Mismatch between Strategic Planning Horizons & Fiduciary Duty for Sustainable Societal Wealth / Future System Value Creation (Dominic Barton et al, Rising to the challenge of short-termism, Focusing Capital on the Long Term, September 2016)

Johnson & McNeil contrast this with the clear trend of the Delaware courts, since at least 1986, to increasingly stress long-term strategic planning as part of the “best interest” goal of Delaware common law. Case after case decided by Delaware justices hold that Directors must “maximize the value of the corporation over the long term.” Johnson & McNeil then emphasize this by pointing out that “there is no common law that clearly establishes the opposite. That is to say, there is no clear Delaware authority condoning a corporate director that destroys the long-term future of a company for short-term profit.”

They then proceed to quote Chief Justice Leo Strine to further solidify the Delaware court’s antipathy to short-termism, and its embrace of long-term value generation:

[M]ost of us think the market’s fetishistic preoccupation with quarter-to-quarter profits is stupid. Anyone who is honest will admit that this obsessional behavior contributed to wrongdoing at corporations like Enron and HealthSouth.
It is well known that businesses aggressively seeking profit will tend to push right up against, and too often blow right through, the rules of the game as established by positive law. The more pressure business leaders are under to deliver high returns, the greater the danger that they will violate the law and shift costs to society generally, in the form of externalities.

In a “seminal” 2010 paper, Chief Justice Strine builds upon these foundations toward the logical conclusion that the ultimate role of the corporation is to create “durable, long-term wealth,” which he further characterizes as “societal wealth” and finally refines to “sustainable wealth.”

Johnson & McNeil use this as a foundation upon which to build their case for “future value,” which is of course consistent with the needs of pension funds, with generation-spanning commitments to their beneficiaries. Pension funds are thus perfectly positioned to initiate litigation against companies for prioritizing short-term value extraction over future value creation. Johnson & McNeil end their article noting that there “would be no better time to bring such litigation than when a court encourages it.”

Why it’s important?

This stance aligns closely with Reporting 3.0’s advocacy that the proper purpose of the corporation in society is to generate what we call “true future value” and “system value.” In other words, companies should not only create value in the form of financial capital for their shareholders and broader stakeholders, but also companies should create value for the economic, social, and ecological systems within which these companies operate, in the form of natural, social, and human capital. Such system value creation is not simply altruism, but rather, it is application of enlightened self-interest to ensure the ongoing viability of the systems companies rely upon as the foundation for their own value creation.

How can you tackle it?

  • Shift from ESG Push to GSE Pull

Reporting 3.0 has long argued for a shift from the current strategy of what we call ESG push, to what we call GSE pull. ESG push is best characterized by the 400+ shareholder resolutions filed each year on Environmental, Social, and Governance issues that seek to pushcorporate directors toward stronger ESG practices. This system is predicated on lagging leadership by corporate directors.

Reporting 3.0 advocates for a system where strong corporate governance plays a leading role, and so we flip the order from ESG to GSE, which provides the governance pull instigating progress. In essence, we believe that corporate (as well as investment, NGO, foundation, etc) boards have the opportunity (and responsibility) to play leadership roles in transforming the economy. We believe that such leadership is in the best interest of companies and investors, from financial and system value perspectives, and thereby in the best interest of society.

  • Enact Strategic Duty

Of course, this requires a paradigm shift for boards from a compliance mindset to a strategic mindset when it comes to fiduciary duty. Van Clieaf calls this Strategic Duty, and he points to the pivotal role climate change plays in triggering this shift:

The COP21 targets for 2050 are crystallizing the Strategic Duty of directors as a core foundation of corporate law and corporate governance to set the minimum standard for longer term strategic and investment planning, business model viability and risk assessment, and meaningful process and duty of care / duty of loyalty to the enterprise, its stakeholders and its longer-term transformation to achieve a net zero GHG business model in line with IEA scenarios.

The “Elephants in the Room” article proposes a laundry list of tangible Strategic Duty processes, including:

  • A process for strategic and scenario planning 5 to 10 to 15 years into the future;
  • A process for setting 5 to 10 year strategic goals and targets;
  • A process for assessing risk to current business model 5 to 15 years into future;
  • A LTIP design goals and pay for performance align for 5 years plus goals;
  • A process for measuring or reporting Future Value;
  • A process for reporting CEO and named officer succession planning aligned to strategy for the next 10 years;

What will you have achieved?

In essence, the shift from ESG Push to GSE Pull and from a compliance-oriented approach to fiduciary duty to an innovation-oriented approach to Strategic Duty promises to trigger a paradigm shift from the current short-term value extraction regime to a system value creation regime that attends to intergenerational equity. This transformation also flips on its head the traditional notion that addressing environmental and social challenges is a drag on business performance and profit; indeed, managing environmental and social impact within key ecological and societal thresholds is a keystone for sustainable value creation in the long-term.

What questions will be discussed next time?

How Can Organizations Align Leadership with Work Levels to Harness Transformative Potential? Please find part 11 here.

Please add your feedback, the authors Ralph Thurm and Bill Baue of Reporting 3.0 will look at all responses. Don’t forget to ‘wave’ if the above resonated with you ;-).

[Context of this series: This is part 10 of the Reporting 3.0 series that forms the basis of an Implementation Guide that summarizes the total value of Reporting 3.0 in implementing a future-ready sustainability strategy and disclosure approach, in line with the idea of a Green, Inclusive and Open Economy. By posting these articles here Reporting 3.0 seeks feedback in the writing process of the final document, to be released as Blueprint 5 at the 5th International Reporting 3.0 Conference in Amsterdam, The Netherlands, on June 12/13, hosted by KPMG, see www.2018.reporting.org]