Boards face new social responsibility*

Directors now have to balance stakeholders’ demands with shareholders’ interests

By Mark Schacter

*This is an expanded version of a summary that originally appeared in the May 2005 issue of CAmagazine.

The international newsweekly The Economist concluded recently that a corporate director in today’s environment has “the job from hell.” And indeed, a string of corporate scandals over the past four years has caused investors and regulators to ratchet up their scrutiny of board members, and elevated the pressure on directors to perform well.

Now, the director’s job promises to become even more demanding. To date, the spotlight on directors has highlighted their traditional role of ensuring that corporate executives run their companies in a manner aligned with the interests of shareholders. But now directors are being pushed into new governance territory occupied not only by shareholders but also by stakeholders – groups such as suppliers, customers, employees, governments and community members whose interests may be affected by corporate decisions. As a group of thought leaders observed at a conference hosted by Harvard University’s Kennedy School of Government, “There will be increased pressure for directors to demonstrate that they have adequate understanding of stakeholder interests.”

The notion that corporations need to attend to social, environmental and economic demands imposed by stakeholders, as well as financial demands coming from shareholders, is commonly referred to as “corporate social responsibility,” or CSR. While most corporate directors are, at the very least, familiar with this concept, many are still seeking clarity about their role in relation to it. The question is, should CSR be considered a strategic corporate issue that requires close board oversight?

The answer is found by digging beneath the jargon that clouds much of the current CSR debate, and exploring CSR’s real implications for corporate decision-making. Do this, and you’ll find that the discussion about CSR is really a special kind of discussion about corporate governance, which means that CSR belongs squarely on the board’s agenda.

Governance & CSR in the lumber yard
To understand the link between CSR and corporate governance, consider the Home Depot story. In 1998, the world’s largest lumber retailer was under attack. The Rainforest Action Network (RAN), an environmental advocacy organization, was accusing Home Depot of doing business with suppliers whose logging practices were said to be destroying old-growth forests. In a well-publicized campaign, RAN labeled Home Depot “the biggest old-growth retailer in the world,” and organized protests at Home Depot stores, the corporation’s headquarters and shareholder meetings.

Concerned about the risk to its reputation, Home Depot responded. Within 10 months, the retailer announced a plan to phase out the sale of lumber originating in endangered forests. It created an executive position – “environmental global project manager” – and gave that person the authority to cancel logging contracts with suppliers who used environmentally unsound practices.

Fast-forward to today. Home Depot now has systems for tracking the origin of every wood product it sells. It publicly pledges not to purchase uncertified wood products sourced from 10 vulnerable forest regions, and not to accept products made from 40 tree species listed as endangered. RAN has openly praised Home Depot’s “impressive” actions, and a feature article in The Wall Street Journal showcased the company as an example of how to manage risks arising from demands imposed by stakeholder activists.

Stories like the Home Depot case are typically discussed under the heading of CSR. But through its interaction with RAN, Home Depot quickly learned that when you scratch the surface of what is usually labeled “CSR,” you find corporate governance. What, after all, was RAN really after?

Power and accountability
The immediate issue for RAN, to be sure, was minimizing environmental damage linked to logging practices. But the activist organization was also forcing a deeper dialogue about:

• how to constrain the power of the corporation;
• the limits within which the corporation should pursue shareholder interests;
• how decisions should be made about striking a balance between shareholder interests and broader social interests;
• the parties that ought to have a say in corporate decision-making.

This is the stuff of corporate governance, which is all about the formal and informal rules and practices that determine how corporate power is exercised, how corporate decisions are taken, and how corporate decision-makers are held accountable. As Sir Adrian Cadbury, a pioneer of recent corporate governance reform, has observed, the aim of corporate governance “is to align as nearly as possible the interests of individuals, corporations, and society.” Directors will be better prepared to play their oversight role with respect to corporate executives if they approach CSR in this light. The alternate view, which sees CSR and corporate governance as distinct issues, risks distracting corporate directors from recognizing a fundamental shift in the “rules of the game” that is affecting the exercise of corporate power, the accountability of corporate decision-makers and the range of risks to successful corporate performance that directors need to follow.

New rules of the game
What are the new “rules of the game” that are behind the convergence of CSR and corporate governance, and that are requiring corporate directors to reassess their responsibilities?

The “new rules” have two key features. The first is the entry of new players – stakeholders – into the governance system that affects the exercise of corporate power. The second is that stakeholders are using their growing influence and sophistication as a way to increase pressure on corporations to take responsibility, and be accountable, for the social, environmental and economic impact of their decisions. As the RAN/Home Depot story illustrates, activist stakeholders are gaining influence over corporate decision-making. A similar pattern is visible in other well-known cases where stakeholder groups succeeded in affecting corporate policy on environmental and social questions. Notable examples include high-profile stakeholder advocacy campaigns directed at corporations such as The Gap Inc., Nike Inc., Royal Dutch/Shell and Talisman Energy Inc. on issues ranging from “sweatshop” labor practices in third-world factories to the impact of corporate operations on impoverished and strife-torn countries such as Nigeria and Sudan.

In all of these cases, stakeholders made claims on the corporation – not the financial claims a shareholder makes, but social claims. And, to varying degrees, the corporations treated these claims as legitimate, altered their decision-making and allowed stakeholder preferences to constrain the exercise of corporate power. The corporations treated stakeholder representatives as if they were shareholders, even though there was no formal requirement that they do so. They responded to stakeholders as if they had a right to a say in how the company was operated. Deliberately or not, they gave stakeholders a role in the governance system that controls the exercise of corporate power.

What is behind this transformation? The answer lies in the convergence of factors such as:

• Globalization: There are approximately 60,000 multinational corporations in the world. Perceptions about the growing reach and influence of global enterprises has drawn attention to the impact of business on society. This has led to heightened demands for corporations to take responsibility for the social, environmental and economic effects of their actions.
• Loss of trust: High-profile cases of corporate financial misdeeds have contributed to a broad-based decline in trust in corporations and corporate leaders. This has led to intensified scrutiny of corporate impact on society, the economy and the environment, and greater readiness to assume (rightly or wrongly) nefarious corporate intent.
• Civil society activism. The growing activity and sophistication of “civil society” organizations has generated pressure on corporations to take CSR seriously. Feisty non-governmental organizations (NGOs) such as RAN have influenced corporate decision-making in areas such as access to essential medicines, labour standards, environmental protection and human rights. The Internet has given these organizations a greater ability to monitor corporate behaviour and mobilize public opinion.
• Institutional investor interest in CSR. The growth in “socially responsible investing” has created institutional demand for equity in corporations that demonstrate a commitment to CSR. In the US at the end of 2003, US$2.2 trillion in assets – 11% of all assets under professional management – were in professionally managed portfolios that used socially responsible investing strategies.

Four major trends
The bottom line: where once directors were asked to look out for shareholder interests, they are now beginning to be asked to serve as the stewards of stakeholder interests as well. This discussion about corporate accountability to stakeholders, while often couched in the vocabulary of CSR, is really a discussion about corporate governance, which is precisely why it demands a central place on the board’s agenda.

Looking ahead, four major trends are likely to emerge in this area that will have an important impact on the corporate director’s job:

• growing pressure on corporations to give stakeholders a role in corporate governance;
• growing pressure on corporations for more thorough disclosure regarding their management of social, environmental and economic issues;
• tighter regulation of elements of corporate activity that are currently regarded as voluntary forms of social responsibility;
• growing interest by the mainstream financial community in the link between shareholder value and non-financial corporate performance.

Pressure to give stakeholders a role in governance
With a growing number of stakeholder groups demanding influence over corporate decision-making, corporations will have to become more sophisticated in making choices about the parties with whom they will engage in civil society. And once partners are selected, corporations will have to become more adept in terms of how they interact with influential interest groups.

Directors will have to be knowledgeable about and watchful of this governance process. A study published last year showed important gaps in this area. It found only 4% of Canadian boards had a committee that focused on “public policy and social responsibility,” and only a quarter had formal processes for overseeing
“non-shareholder interests.”

Pressure for social, environmental and economic disclosure
Corporations have begun to respond to heightened demands from stakeholders for reporting on social, environmental and economic impacts – so-called “triple-bottom-line” reporting – in addition to customary disclosure of corporate financial performance and risk. The number of companies worldwide producing significant corporate social reports swelled from virtually nil in 1990 to more than 1,500 today. Because corporate social reporting is at a very early stage, a number of significant matters remain to be resolved. Key outstanding issues are standardization and assurance. There are no “generally accepted accounting principles” for social reporting. An emerging de facto standard is the set of social reporting guidelines first published in 2000 by the Global Reporting Initiative (GRI), a multi-stakeholder initiative involving NGOs, the investment community, assurance providers and regulators.

Young as social reporting is, assurance of social reporting is younger still. The first social reporting audit standard was published in 2003 by a UK-based think tank, AccountAbility. Much work remains to be done to build broad-based consensus around audit and assurance of corporate social reports.

More regulation
CSR is commonly regarded as what a company does that exceeds legal requirements. As society’s views evolve regarding acceptable standards of corporate behaviour, items migrate from the realm of corporate discretion to that of regulatory compulsion. Child labour is an obvious historical example; others include the minimum wage, statutory holidays, workplace safety, employment equity, racial discrimination, environmental protection, product safety, food labeling and advertising of alcohol and cigarettes.

It is reasonable to assume that pressure to push things across the boundary from discretion to compulsion will intensify. Recent examples provide a sense of some areas in which this process is unfolding:

• The state of Maine passed legislation requiring manufacturers to share responsibility for the recycling of televisions and computer monitors.
• Canada passed a law making it easier to lay criminal charges against corporations for workplace health and safety violations. The British government has proposed similar legislation.
• Denmark responded to health concerns about trans fatty acids (a common ingredient in processed foods) by enacting regulations limiting the amount of trans fat that may be used by food manufacturers.

One area that will be of particular interest to directors, because of their duties related to oversight of corporate disclosure, is the trend toward increased regulation of corporate disclosure of non-financial, “triple-bottom-line” information. Recently, governments around the world have shown increasing willingness to intervene in the area of corporate social reporting. For example:

• Canadian securities regulators have introduced rules requiring listed companies to describe their “fundamental” social and environmental policies and the steps they are taking to implement them.
• Britain plans to require publicly traded companies to disclose information related to the environment, social and community issues, employees and customers.
• France has enacted rules requiring listed companies to report publicly against certain social and environmental indicators.

More interest from the financial community
The mainstream financial community has been slow to acknowledge links between a corporation’s non-financial performance and its capacity to generate a financial return to shareholders. There are signs this may be changing. One indication was the recent decision by Standard & Poors (S&P) to partner with the UK-based think tank SustainAbility, and the United Nations Environment Programme, in the production of a highly regarded international review of corporate non-financial reporting. S&P, a global provider of corporate analysis and risk assessment to financial markets, attributed its participation to the “growing importance of non-financial disclosure in the overall assessment of a company’s risk profile.” S&P said the identification and management of social and environmental risks facing the corporation “should have explicit board oversight.” It said that when conducting an assessment of corporate risk, it would be “alarming” if it found that board oversight of social and environmental risks was non-existent or minimal.

The challenge ahead
CSR is about widening the range of players deemed to have a legitimate role in shaping corporate decision-making and controlling the exercise of corporate power. It is, in other words, a governance issue. The implication for corporate directors is that they will need to develop a greater appreciation of the new governance environment within which publicly traded corporations are operating.

Going down this road will not be easy, and is likely, on occasion, to generate controversy. The emerging field of social reporting, which will undoubtedly demand increasing board attention in the years to come, remains to be codified and standardized. Governments are still feeling their way around the relative merits of regulatory versus voluntary approaches for managing corporate impact on society, the economy and the environment. Corporations themselves remain uncertain about how best to reconcile shareholders’ short-term demands for earnings and share-price growth with stakeholders’ pressure for a longer-term focus on society, the environment and the economy.

The biggest challenge for directors will be to ensure the corporation navigates the best possible path among the competing claims of shareholders and stakeholders. Boards will have to deepen their understanding of the networks of relationships – social as well as financial – that sustain the corporation. They will have to heighten their sensitivity to non-financial risks, and build their capacity to oversee the corporation’s response to intensifying demands from governments and the financial community for greater rigor in the management of, and disclosure about, the corporation’s social, environmental and economic impact.

Mark Schacter (http://www.schacterconsulting.com/) advises governments, international agencies and private corporations on practical and policy issues in governance, corporate social responsibility, accountability, and ethics. He can be reached at (613) 277 6777 or mark@schacterconsulting.com.

Notes:
For more information on CSR, please visit the sites mentioned in the right-hand column, as well as the publications listed below. Of the three books/articles, the first (published by CICA two years ago) and the second deal with the practical question of engaging with civil society. The third article discusses best practices in social reporting.

Stakeholder Relationships, Social Capital and Business Value Creation, by Ann C. Svendsen, et. al., Toronto: Canadian Institute of Chartered Accountants, 2003.

“Civil Society and Public Governance. Getting a Fix on Legitimacy,” by John Saxby and Mark Schacter, Ottawa: The Conference Board of Canada, 2003.

“Risk & Opportunity. Best Practice in Non-Financial Reporting,” London: SustainAbility, 2004.