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AccountAnts for business

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about aCCa

ACCA (the Association o Chartered CertiedAccountants) is the global bod or proessionalaccountants. We aim to oer business-relevant,rst-choice qualications to people o application,abilit and ambition around the world who seek arewarding career in accountanc, nance andmanagement.

Founded in 1904, ACCA has consistentl held uniquecore values: opportunit, diversit, innovation, integritand accountabilit. We believe that accountants bringvalue to economies at all stages o their development.We seek to develop capacit in the proession and

encourage the adoption o global standards. Ourvalues are aligned to the needs o emploers in allsectors and we ensure that, through our qualications,we prepare accountants or business. We seek to openup the proession to people o all backgrounds andremove articial barriers, innovating our qualicationsand their deliver to meet the diverse needs o traineeproessionals and their emploers.

We support our 140,000 members and 404,000students in 170 countries, helping them to developsuccessul careers in accounting and business, basedon the skills required b emploers. We work through a

network o 83 oces and centres and more than8,000 Approved Emploers worldwide, who providehigh standards o emploee learning and development.Through our public interest remit, we promoteappropriate regulation o accounting and conductrelevant research to ensure accountanc continues togrow in reputation and inuence.

about aCCountants FoR business

ACCAs global programme, Accountants or Business,champions the role o nance proessionals in allsectors as true value creators in organisations.Through people, process and proessionalism,accountants are central to great perormance. Theshape business strateg through a deep understandingo nancial drivers and seek opportunities or long-term success. B ocusing on the critical roleproessional accountants pla in economies at allstages o development around the world, and indiverse organisations, ACCA seeks to highlight andenhance the role the accountanc proession plas insupporting a health global econom.

.cc.cm/cc_

The challenge or businessentities o all kinds is to ensurethat the business rewards theseek are supported b sensiblemanagement o the risks thatconront them.

Those who govern entities are

responsible or ensuring thatthe pa due attention to allmaterial risks, including ethicaland behavioural risks.

This paper contains a number oindividual perspectives on thesethemes.
http://www.accaglobal.com/accountants_businesshttp://www.accaglobal.com/accountants_business


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The Association o Chartered Certied Accountants (London)


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The Council o the Association o Chartered Certied Accountants consider this stud to be a worthwhile contribution to

discussion but do not necessaril share the views expressed, which are those o the authors alone. No responsibilit orloss occasioned to an person acting or reraining rom acting as a result o an material in this publication can beaccepted b the authors or publisher. Published b Certied Accountants Educational Trust or the Association oChartered Certied Accountants, 29 Lincolns Inn Fields, London WC2A 3EE.

The Association o Chartered Certied Accountants, March 2011


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RISK AND REWARD: SHARED PERSPECTIVES 3

C

Foreword 5

1. Capitalism and the concept o the public good 7

Paul Moxe, head o corporate governance and risk management, ACCA

2. Company law and the concept o corporate social responsibility 11

John Davies, head o technical, ACCA

3. Making businesses more accountable to investors 15

Louise Rouse, director o investor engagement, FairPensions

4. Learning rom environmental credit risk management 19

Dr Andrea B. Coulson, senior lecturer in accounting, Universit o Strathclde andchair o ACCAs sustainabilit committee

5. Avoiding bear-traps: an investor tool or identiying and managing business ethics risks 21Seb Beloe, head o SRI research, Henderson Global Investors andMark Anderson, director, Forensic Services, PwC

6. Ethics: does ethical governance actually lead to better organisational perormance? 27

Gillian Fawcett, head o public sector, ACCA

7. Ethical leadership: lessons rom two biographies 30

Paolo Giusta, European Commission

8. Measuring ethical perormance 33

Dr Michael Macaula, Reader in Governance, Teesside Business School, Universit o Teesside.

9. Ethical governance and the Audit Commission 38

Alison Kell, national lead, governance and accountabilit, Audit Commission

10. Assuring company integrity introducing a tool to protect reputation and shareholder value 41

Eoin McCarth, consultant, Threshold Consulting Ltd.

11. Ensuring good ethical governance in partnership arrangements 47

Dr Gar Hicke and Piers Bainton, Standards or England

Reerences 53


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FOREWORDRISK AND REWARD: SHARED PERSPECTIVES 5

Frr

In 2010 ACCA published Risk and Reward: Tempering the Pursuit o Prot. Thatpaper explores the nature o the dnamics that drive corporate planning andaccountabilit, ocusing on the broad range o risks which need to be identiedand managed.

One o the areas o risk that warranted particular attention, the paper suggests,is the matter o behavioural risk. It argues that while guidance, standards andsupervision undoubtedl have a role to pla in regulating corporate activities,those activities are ultimatel the result o the behaviour o companies leadactors. That paper contends that, whether regulator standards o various kindsare ramed as rules-based or principles-based, what will alwas be oundamental importance is the preparedness o companies to appl themhonestl, ethicall and transparentl.

Accordingl, i business is to be conducted in a wa which is going to beconsistent with the interests o investors and wider societ, more attentionneeds to be paid to how this issue o behavioural risk can be interwoven withregulator mechanisms so as to ensure, as ar as is practicable, that directorsand executives act in accordance with the spirit as well as the letter o law and

standards.

ACCA is pursuing this agenda in its own activities and on behal o its membersb promoting the concept o public value. This entails acting not onl in thepublic interest but also in a wa which delivers added value to stakeholdersthrough, or example, good corporate governance, enabling access to nance orprotecting clients wider interests.

In this ollow-up paper, we oer a collection o individual perspectives on theissues explored in that earlier stud. We look at how investor groups see thesignicance o risk and pose the question o whether it is easible to expectcommercial businesses to operate in accordance with some conception o thepublic good. We also broaden out the scope o the earlier paper backnowledging that the issue o behavioural risk impacts on the public sectorjust as it does the private sector. A number o contributions address theapplication and measurement o ethical principles and consider how thoseprinciples might impact on perormance.

ACCA thanks all the authors or submitting their work and trusts that it willprove a thought-provoking contribution to the debate.

John DaviesACCA Head o TechnicalMarch 2011


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1. CAPITALISM AND THE CONCEPT OF THE PUBLIC GOODRISK AND REWARD: SHARED PERSPECTIVES 7

Rules and Regulation

How could we bring this about? The response ogovernments, indeed almost anone in a position oauthorit, is to think about making more rules. But havingmore rules is not the answer, the nancial crisis havingexposed their limitations. A compliance mind-set meantthat people did not have to worr about whethersomething was right or wrong or even sensible. Theshadow banking sstem, the massive build-up o debt andleverage might not have happened i the Basel rameworkhad not created the opportunit. The US CommunitRe-Investment Act o 1977, which outlawed discriminationb banks against low-income households, was also anunwitting catalst or the crisis. There is also an argumentthat nancial reporting and auditing standards havebecome too rigidl based on rules. The accountingproession is again questioning the purpose o accountingand auditing and asking whether it is sucient to compl

with relevant technical standards. The InternationalFederation o Accountants is currentl consulting on apublic interest ramework.

ACCA has long held the view that principles are moreimportant than rules. Nonetheless, some people do notlike principles on the grounds that the create too muchambiguit, while a ew want to know what the can getawa with. A principle such as substance over orm canseem too restrictive i there is the possibilit that a courtor disciplining bod might sa that a particular action waswrong. People like certaint about what the can andcannot do. The less well intentioned are, o course, entirelcomortable with principles i the are never enorced, so itis necessar that people can be held to account i the ailto uphold principles.

Have we reached a point where there are just too manlaws and rules? Should we tr to return to a situationwhere there is more emphasis on common law, whereactions are interpreted according to precedent, principleand common sense rather than compliance?

What shocks ou? Ater corruption scandals involvingpoliticians, ailed and ailing pensions, ee-watering sumsto bail out banks and slightl smaller but still ee-wateringbonuses in the nancial sector, our capacit or outrage hasbeen dulled. There is a sense o resigned acceptance thatthere is little that people can do about it and that we anduture generations o taxpaers will be worse o or earsas a result. Such acceptance is tempered with a growingcnicism and lack o trust in politics, nance and business.

Following ears o industrial unrest in the 1970s, whenbusiness was branded b man as a villain, a widespreadview emerged in the 1980s that ree markets were a goodthing, and that the less business and nance wereregulated the better it would be or societ as a whole.Financial services became the engine o growth. Economicprosperit increased or most people but the gap betweenrich and poor widened dramaticall. Then came thecrunch. We still do not know whether the nancial crisis

caused just a nast but relativel short blip in economicgrowth or is still causing something worse. It does,however, seem alread to have claimed man innocentvictims across societ, including elderl people tring tolive o the interest rom savings.

It is now clear that an unettered market ma not be thebest one. As has happened beore, ater Enron collapsed,there is more talk now about ethics. But, apart rom saingthere was too much greed, it has been dicult to point toan particular ethical ailing, except where we know thatlaws were broken. We know that ollowing the rules doesnot necessaril equate with good ethics. In act, we haveseen man examples where practices that ailed the test opublic acceptabilit were met with the deence that wewere ollowing the rules. Unortunatel, gaming-the-rulesrather than plaing-b-them became common.

Capitalism cannot exist without societ, and societ wantsor needs capitalism to raise standards o well-being. In anideal world there would be a in-ang relationship betweencapitalism and societ, where capitalism benets societand societ enables responsible capitalism to ourish.Unortunatel some see societ as, in eect, capitalismspre and this ts well with our want it now culture. Theimage o a hunter who eats what s/he kills makes a poormetaphor or business it corrodes trust; a better one is

o a armer who grows ood and husbands livestock whilelooking ater the environment. This approach builds trustand that is good or business and or societ, and itnecessitates a long-term approach.

1. Cpm ccp pc

P M, crpr rc r mm, [email protected]
mailto:[email protected]:[email protected]


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MeasuRing value

Adam Smith divided incomes into prot, wage and rent. Inprot-seeking behaviour, entities create value in acompetitive environment b engaging in mutuallbenecial transactions. This is the invisible hand thatpromotes the public good, irrespective o the intention othe prot seekers. In rent seeking, wealth is transerredrom one part to another through the recipients abilit tobenet rom special privileges conerred b avourable orill-conceived regulation. Such privilege might includebenets rom monopol or oligopol, quotas, licensing,regulation and state support. Rent-seeking behaviour doesnot add value, nor does it serve the public good.

These das, because legislation and regulation are soentwined with business, it is oten hard to distinguish thetwo tpes o income. The act remains though that rentseeking is likel to eature wherever prots are made that

are higher than can be explained b competitive orcesalone. This clearl applies to the protabilit o the bankingsector. A shortcoming o our present reporting rameworkis that it does not distinguish between prots that areearned rom value-creating behaviour in a competitiveenvironment and transers o wealth through rent-seekingbehaviour. There is a role or the accountanc proessionin developing new was o measuring and reporting onvalue creation.

There are, however, problems with measurement. Onesuch problem is that o achieving appropriate precision.Valuation o hard-to-value items, such as land during arecession or mortgage-backed securities during a creditcrunch, cannot be precise; et nancial statements do notconve that some valuations ma be little better than aguess. Another problem is that an inormation derivedrom comparison with social or economic measures canbe misleading or dangerous. This phenomenon issometimes known as Goodharts Law ater the economistCharles Goodhart. It means that a measure turned into atarget or polic will lose the inormation content thatqualied it to pla the role in the rst place.

A craz example is a Soviet-stle actor, which, given thetarget o producing as man nails as possible, produceslots o tin useless nails and, when given a target based on

weight, produces a ew ver heav nails. This might soundlike an argument or ree enterprise but the phenomenonis prevalent in market economies and especiall in areas

where governments want market orces to operate in aregulated environment. This includes banking and thehealth sector. The public sector is plagued with examples,such as a hospital that introduced a waiting list or goingonto a waiting list, when healthcare-sector waiting listsbecame a target to be managed down. In banking, theBasel ramework acilitated the shadow banking sstemand a dependenc on credit ratings. In one o the ewmanagement accounting novels, The Goal, E. M. Goldrattshows how seemingl sensible production targets couldlead to bottlenecks and to bankruptc.

New thinking is needed. It is now widel recognised that achange in culture is needed and man people are aware ohow dicult this is to bring about b regulation. The UKcoalition government talks o a Big Societ, an aspirationthat is dicult to dene. But what i our compan law orcorporate governance ramework introduced an explicitrequirement or boards and companies to work or the

public good? This could sit alongside other aims such asmaking a prot.

the PubliC good

The Golden Rule, ound in most o the worlds religions, doto others as ou would have them do to ou, does not givean particular direction or steer. In general, most companand proessional ethics rameworks and codes also do notgive a clear direction: the lack a moral compass. Eventhose that are expressed in terms o values rather thanconduct contain much ambiguit. It is too simple to sa justdo the right thing, but this is the essence o what we need.

A requirement to conduct enterprise or public good mightdo the trick. Everone has a sense o what constitutes thepublic good. There ma be occasions when one personssense o public good ma be another persons idea opublic bad but, i the principle were enorced b the courto public opinion, it could be eective. An bad should beoutweighed b the good at least as ar as societ at antime might judge what good is.

Adam Smith said that b pursuing his own interest aperson requentl promotes the interest o societ moreeectuall than when he reall intends to promote it. Hewas cnical about the good done b people who eected

to trade or the public good. We, however, live in an age omuch greater transparenc and openness. I we had anexpectation that companies, which operate in societ and
http://en.wikipedia.org/wiki/Adam_Smithhttp://en.wikipedia.org/wiki/Profit_(economics)http://en.wikipedia.org/wiki/Wagehttp://en.wikipedia.org/wiki/Economic_renthttp://en.wikipedia.org/wiki/Economic_renthttp://en.wikipedia.org/wiki/Wagehttp://en.wikipedia.org/wiki/Profit_(economics)http://en.wikipedia.org/wiki/Adam_Smith


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1. CAPITALISM AND THE CONCEPT OF THE PUBLIC GOODRISK AND REWARD: SHARED PERSPECTIVES 9

It is implicit that, in having such regard, directors do notcause the compan to harm the communit or theenvironment. An amendment to include explicit reerenceto the public good would merel provide a subtle but vitaldirection.

the Role oF shaReholdeRs

At present this legislation can be enorced onl bshareholders and such enorcement would be dicult toappl to the concept o protecting the public good. It is notclear how, i at all, boards pa attention to theirresponsibilit to the enlightened shareholder.

Given that a substantial proportion o the shares o ourlarge listed companies are owned b institutionalshareholders investing on behal o millions o people, it isreasonable to expect such companies to operate in thepublic good. Most smaller businesses do this alread. To a

great extent, the rel on trust and common sense withinthe business rather than on detailed internal controls tooperate. The are generall ormed and evolve to meet amarket need and in so doing contribute to the public goodthrough Adam Smiths invisible hand; the are not usuallable to exploit the benets o oligopol or game regulation.Nonetheless, a possible exception to the latter could bethe super prots rom propert development during aperiod o credit expansion. This occurs as a result o theplanning sstem, which or understandable reasonsrestricts development.

The next step would be to encourage institutional

shareholders to take an active interest in how theirinvestee companies work in the public good. This could bethe missing part o the FRCs Stewardship Code. The UKCorporate Governance Code, which currentl makes noexplicit reerence to ethics, and which arguabl puts toomuch emphasis on compliance with provisions at theexpense o upholding principles, could also include a mainprinciple that companies work in the public good andrequire companies to report trul and airl how the do so.

need a mandate rom societ to do so, should operate inthe public good as the make prots, then companies willdo that. There is no need to speci how much public goodis done or how the should do it. Qualit reporting aboutwhat is done should mean that companies that areeective in both making prot and doing public good willbe rewarded. It is necessar, o course, that reporting mustbe true and air and that glib, empt or misleadingstatements are dealt with and companies must restrainthemselves rom using such reporting as a public relationsexercise. Our internet age, however, means that aninappropriate reporting is likel to be spotted quickl.

It ma be better not to dene the public good but leave itvague, because more denition could invoke GoodhartsLaw and encourage people to game it. The public good isnot, o course, about economic good alone. Whileeconomic well-being is nice, other things are equall i notmore important. Bhutan has the concept o Gross National

Happiness and, theoreticall at least, is governed so as toraise happiness. Unlike GDP, this is not one target but abasket o targets across nine areas so its susceptibilit toGoodharts Law should be limited.

Although securitisation o loans can serve a valuablepublic good in enabling people with unds to provide themto people wanting them, and or risk to be taken on bpeople best placed to do so, the sstem went o the rails.Financial institutions were able to pass bundles o debtand related derivatives to individuals and other institutionsthat had little idea o what the were buing. Thoseinvolved had ever incentive to game the sstem and noincentive to do a public good. It is hard to envisage howthe resulting bean east could have been described banone as being a public good; a requirement to work inthe public good ma have kerbed animal spirits whenthere was no other restraint.

The concept o public good gives a clear moral steer orcompass but tremendous exibilit in how companies cancontribute.

This idea ma sound radical but the UK compan lawramework alread went some wa towards this when itadopted the enlightened shareholder concept in the UKCompanies Act 2006. The Act coners a dut on directors

to promote the success o the compan and, in the courseo making their decisions to that end, are required b lawto have regard to a number o specic actors.


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doing the Right thing

Considering the public good would also provide adirectional steer or regulation and supervision and couldenable considerable reduction in regulator complexit.

Supervisor action taken transparentl b reerence to thepublic good should be simpler to enorce. A nancialinstitution or compan would have a clear test and wouldknow it might have to explain its actions. Surel this wouldbe better than slavishl checking compliance with aregulation that ma well, in an case, have unintended andunortunate consequences?

Finall there is the intrinsic satisaction that most peoplederive rom doing something good. The overall eectshould be to promote trust, which in turn would promoteenterprise and lead to a healthier, probabl moreprosperous and happier societ and reduce the regulatorburden. It might even help to restore aith in politics.


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The question in whose interests should a compan berun? is one that has sustained debate in compan lawcircles or man decades. The central issue here is this:given that the compan, though a privatel owned vehicle,benets rom material privileges conerred on it b thesociet in which it operates, should not societ, in return,expect the compan to operate in accordance with normso behaviour that the same societ deems appropriate?

Increasingl we are seeing a recognition, in national legalsstems, o the act that companies do owe responsibilitiesto societ beond a dut to pa tax on their prots. The UKis one o the jurisdictions where this is happening.

The reorm o the UKs compan law in 2006 has seen thisconcept o corporate social responsibilit weaved into theexpectations o compan behaviour through the rules ondirectors duties. The reorms made in the Companies Act2006 were intended to generate a subtle shit towards

requiring directors to take into account wider societalactors while ullling their legal responsibilities. The newapproach was labelled enlightened shareholder value, todierentiate it rom the more traditional corporate concepto shareholder primac. But does the reorm that hastaken place here amount to an real change in the wathat compan boards are expected to act, or is it merel asop to stakeholder pressures that does not translate intoan real change in practice?

It is not dicult to see that shareholders are entitled tohave special rights within an compan. It is the who setup the compan in the rst place, set its objectives,appoint its directors, provide its capital and assumeultimate risk in their investments. Given this, it is quitestraightorward to accept that it is the shareholders towhom a compan should be primaril accountable andthe whose proprietorial interests should be primarilreected in the business strategies adopted b directors.

The reorms made b the Companies Act 2006 do notdisturb this position at all. Directors are still required to actin the best interests o their compan and the owe thisdut to their compan alone (in eect to its bod oshareholders). Directors are not made accountable toanone other than their compans shareholders and thereorms do not impose express obligations or them to act

in an particular wa in respect o an given cause orstakeholder group.

What the new Act has done, though, is to stress that whatis in the best interests o a compan or its shareholders isnot something that can be dened exclusivel b theexpressed or perceived wishes o those shareholders:other actors, and the interests o other elements insociet, also have a bearing on a compans ortunes andthose other interests must sstematicall be taken intoaccount in steering the compan orwards. Without laingdown an standard expectation on the matter, the new Actalso implies that directors will not be acting in the interestso their shareholders i the concentrate on short-termeconomic return at the expense o securing sustainableand longer-term success or the compan. Thus theenlightened shareholder value approach now enshrinedin UK compan law attempts to improve the qualit o theboard-level decision-making process b incorporatingwithin it an expressl inclusive approach.

diReCtoRs duty to PRoMote the suCCess oF the

CoMPany

Beore the new legislation was enacted, man argued thatsection 172 o the new Act, which sets out the mechanicso the directors basic dut to promote the success otheir compan, was unnecessar. It would do nothingmore, the argued, than articulate what was in practice thestatus quo, since an well-run board would be expected toact in the was envisaged b the new section. (Theassumption that all companies had adopted this holisticdecision-making process was probabl optimistic, evenbeore the all out rom the nancial crisis became apparent).

Under section 172, directors are required to act in wasthat the consider are likel to promote the success otheir compan. This dut must be observed in all thedecisions and actions that the take on behal o theircompan. The courts will not interere with directorsjudgements on such matters, either prospectivel orretrospectivel, provided the act in good aith. Directorsremain entitled, thereore, to do what the think is right ortheir business.

Nonetheless, the dierence now is that this reedom is notunrestrained. In order to compl with the basic dut,directors must have regard to the specic matters listedin sub-sections (a) to () o section 172(1) (as well as to

other actors that happen to be relevant to the matter inhand).

2. Cmp ccp crpr c rp

J d, cc, [email protected]

2. COMPANy LAW AND THE CONCEPT OF CORPORATE

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There are six specied actors in all:

the likel consequences o an decision in the longterm

the interests o the compans emploees

the need to oster the compans business relationshipswith suppliers, customers and others

the impact o the compans operations on thecommunit and the environment

the desirabilit o maintaining the compansreputation or high standards o business conduct

the need to act airl as between members o thecompan.

brc rcr r c 172Thus, while the law will not intervene in either the exerciseo business judgement in decision making, or in respect othe relative weight applied b directors to the variousspecied actors, directors will not technicall be incompliance with their basic dut under section 172 i thecompletel ail to have regard to an or all o thoseactors (even i the otherwise act in good aith).

So, to take three o the actors set out above as examples,directors now risk being in breach in scenarios such as:

where the make distributions o capital which, even i

the satis the legal test o distributable prots at thetime the decision to distribute is made, have the eecto rendering the compan unable to meet cash owdemands that should have been anticipated and takeninto account

where the ail to take account o identiableenvironmental risks associated with the compansoperations, and ail to take reasonable precautions inrespect o them, and as a result the compan suerscivil and criminal penalties and/or reputational damage

where the knowingl or negligentl allow theircompan to become involved in criminal or unethical

acts that again cause loss or reputational damage tothe compan.

Thus, the ke eect o section 172 is that where directorsail to take account o actors (the specied actors inparticular) that have material implications or the interestso a compan, and that ailure results in some sort o lossto the compan, the could be held to be in breach o theirbasic dut to promote the success o their compan.

Whether directors will in practice be held liable or breacho dut will depend on whether the act in breach o therequirements outlined above and, cruciall, on whethershareholders are sucientl exercised b their directorsconduct to want to take action against them, that is, actionextending beond the options o selling their shares orvoting against the directors re-election. This is where theaim o strengthening the legal controls on directorsactions encounters the corporate governance challenge oachieving improvements in the area o active investment.

ercm c 172

It has been argued that enorcement mechanisms or thenew provisions are weak, and thereore likel to make littledierence in practice to how companies behave, on twogrounds. The rst is that the Act requires directors onl tohave regard to the specied actors (and other relevantmatters). This is a ver light touch requirement. On itsown, it suggests that no substantial degree o time orattention is expected to be given as a matter o course. I aboard is satised that an one or more o the given actorsis immaterial or irrelevant to what the are doing, or i itconsiders that a decision it is minded to take is unaectedb an o the actors to which it is required to haveregard, it will be entitled to do no more than come to that

conclusion.

diReCtoRs duty oF CaRe, skill and diligenCe

In exercising their unctions, however, directors need tobear in mind another o the Acts provisions on directorsduties. Section 174 o the new Act requires them toexercise reasonable care, skill and diligence, qualities nowdened b reerence not solel to the particularbackground o the individual directors the traditional,subjective test o skill and care but also to the qualitiesthat are to be expected o an person carring out theduties o the director concerned this is a new objectivetest o skill and care. Thus there is now an objective

benchmark o the skill, care and diligence with which thelaw expects ever individual director to compl.


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Accordingl, the law will expect directors, in the course ocompling with the basic dut in section 172, to exercisereasonable skill and care in:

identiing the actor or actors that will be particularl

relevant to an given action or decision, and then

paing an appropriate degree o attention to therelevant actor or actors.

Directors must thereore compl with the dut to promotethe success o the compan, in parallel with their dut oskill and care.

The second alleged weakness o the Act is that sincedirectors owe their legal responsibilities onl to theircompan, the law is powerless to ensure that companiesrespect, or example, ethical business standards, since nothird part claiming to represent the interests o such

standards is entitled to hold the directors to account.

Again, this is true: boards that maintain good relationswith their shareholders are not likel to experience anpressure rom the shareholders to uphold the interestsrepresented b such standards.

shaReholdeRs Rights

In a gesture designed to give some teeth to the provisionson directors duties, shareholders do now have the right tointervene through the courts i the think that directors arenot living up to their legal responsibilities. Under section

261 o the new Act, an one or more shareholders maseek to commence legal proceedings against theircompans directors, in the name o the compan, orbreach o their duties as directors.

It will not be eas or shareholders to do this. There are anumber o conditions that the must satis i the are tobe allowed to continue the claim against their directors inthe courts: conditions designed to discourage rivolousactions or actions b single issue shareholders. One othese tests is whether the shareholders claim would belikel to have been brought b an director who was actingin accordance with the basic dut in section 172. In eect,the court will orm a view as to whether the respondent

directors behaviour was consistent with the dut topromote the success o the compan, including theobligation to have regard to the actors considered above.

While enorcement o section172 will be a matter or theshareholders and them alone, the cause o shareholderengagement in UK compan aairs has been givensignicant backing in 2010 b the Walker review ocorporate governance in banks and b the UK StewardshipCode, which has been issued b the Financial ReportingCouncil subsequent to Walkers recommendations. Thenew Code recommends that institutional investors pla amore proactive and interventionist role in the aairs o thecompanies in which the invest. It calls on them to monitortheir investee companies activel, to adopt clear guidelineson when and how the might improve their engagementwith those companies, and to be prepared to actcollectivel with other investors where appropriate. Anremedial action considered b major investors is rarellikel to extend as ar as pursuing directors or breach odut but this will be an option or them and should not betotall discounted, especiall i institutional investorsconsider that the interests o their own benecial

stakeholders have suered as a result o directors actions.

Even where shareholders show no interest in enorcingdirectors duties under section 261, it should also beexpected that the actions o directors, where the havecaused loss to their compan, will be reviewed at someuture stage b a uture liquidator, with a view torecovering monies owed to the compan. Consideration odirectors conduct under other legislation, or example inrespect o the corporate oence in the Briber Act 2010,can also be expected to be undertaken b reerence to theduties the have under the Companies Act.

the CuRRent Position oF diReCtoRs

So where does this leave a compan and its directors?Fundamentall, the remain entitled to commit theircompanies to the pursuit o protable business ventures.Making mone, and making prots, is ater all what mostbusinesses exist to do. I directors were not eective inthese things their shareholders would probabl considerthat the were not serving their interests properl (in legalterms the might argue that the directors were notpromoting the success o the compan) and wouldprobabl respond b either voting to sack the directors orselling their investments. The reorms made b theCompanies Act 2006 are not, thereore, intended to

prevent compan directors rom taking risks in the pursuito prot, and the do not in themselves penalise directorsin cases where the get things wrong, in the sense that

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the cause the compan to lose mone on projects orinvestments or to become insolvent.

I an signicant change has occurred, it is a subtle one,though nonetheless one that is important or directors andall corporate stakeholders. While the law agrees thatdirectors are entitled to take risks on behal o theircompan, and are ree to make judgements as to whatcourses o action are likel to be in their compans bestinterests, their reedom to do this is not unrestrained. Theare now expected to act, and to make their decisions, inthe light o a more structured assessment o how dierentactors and interests will aect those acts and decisions orbe aected b them. While the are not steered to arrive atan particular conclusion as a result o this process, andare ree to attach whatever weight the think appropriateto the dierent actors the consider, a complete ailure toobserve the due process will expose them to compliancerisk and conceivabl legal action initiated b their

shareholders.

The main result o the UK reorm, thereore, is that theidentication and management o business risks is nolonger (merel) something that well-run and responsiblecompanies should be doing in their own materialcorporate interests: it has become an activit that also haslegal status. As such, non-compliance with the new legalexpectations has become a risk actor in itsel. And icompanies do not respond appropriatel, the law has giveninvestors the means to intervene. The ball is now in theircourt.


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3. MAKING BUSINESSES MORE ACCOUNTABLE TO INVESTORSRISK AND REWARD: SHARED PERSPECTIVES 15

Fort ears ater Milton Friedmans seminal essadismissing calls or the imposition o social responsibilitieson business, corporate social responsibilit (CSR) has,nonetheless, entered into the business mainstream.Despite the prolieration o corporate CSR departmentsand sustainabilit reports, however, it remains the casethat or man companies, engaging with environmentaland social risks is seen as an optional bolt-on largelocused on cost reduction and reputational benets ratherthan as an essential component o eective riskmanagement and strategic decision making. Meanwhile,events in the real world have made it clear that such risksma be highl material to corporate success andsustainabilit, deserving the attention o senior directorsconcerned with the core o corporate strateg.

The problem, as FairPensions sees it, is not so much acase that CSR is greenwash but that companies areailing to appreciate ull the relevance o environmental,

social and governance (ESG) issues to long-termperormance. Institutional shareholders and the individualson whose behal the invest are suering the nancialconsequences o this corporate ailure. We do not seek tore-open the Friedman debate on whether companies havewider social responsibilities. Rather, the debate must moveon to assess whether companies are ocusing onidentiing, reducing and managing those material risks totheir businesses that arise rom ESG issues. This chapterseeks to address wh so man participants in theinvestment chain are still missing the point when it comesto the materialit o environmental and social issues tocorporate perormance and what regulator andbehavioural changes are necessar to ensure that CSRmoves beond emploee volunteer programmes andphilanthropic donations to being at the centre o eectivecorporate risk management and strategic decisions.

esg issues as MateRial FinanCial Risks

As an example o the consequences when companiesinadequatel assess ESG risks, one need look no urtherthan the nancial crisis and its roots in inadequateassessment o the risks o short-term business models,remuneration policies and provision o excessive credit.The ear 2010 has seen urther examples o the nancialimpacts o inadequate risk assessment and management.

The allout rom the Deepwater Horizon re andsubsequent oil spill provides a stark warning or

corporations who ail to recognise environmental andsocial impacts as a necessar element o eective riskmanagement. To date BP plc has incurred an estimatedtotal charge o $39.9billion, seen its share price alldramaticall and suered unprecedented damage to itsbrand in the United States o America. And et BP plc, likeman o the banks rescued b taxpaers across the world,has man o the policies and practices one associates withthe now-accepted view o corporate CSR: it has adedicated corporate social responsibilit department,makes public statements on the importance oenvironmental matters and has a strong commitment toarts sponsorship in the UK. Despite this, the Gul o Mexicodisaster suggests a ailure b BP plc to ocus closelenough on social issues such as health and saet ailingsand environmental impacts and to incorporate theseactors into senior-level decisions and practices.

BPs shareholders were not alone in suering the

consequences o ailing to integrate social responsibilitconcerns into business decisions. On 23 August 2010, theLondon-listed Indian mining compan, Vedanta Resources,saw its share price all ollowing a decision b the Indiangovernment to reject its plans or a bauxite mine onenvironmental and social grounds (Responsible Investor 2010).

Changing CoRPoRate behaviouR: the Role oFinvestoRs

Unortunatel, it is unlikel that the occurrence o theserecent events will be sucient to ensure adequateconsideration o ESG issues at a corporate board levelwithout a corresponding change in investor behaviour.Investors ought to be the ke plaers in ensuring thatenvironmental and social matters that pose material risksor companies are placed at the centre o corporatedecision-making practices. Apparentl this is somethingthat top compan executives would like to see and regardas necessar or acilitating change at a corporate level. Arecent surve carried out b the UNPRI and Accentureamong international CEOs ound that 86% o respondentCEOs want institutional investors to take a lead in ensuringthat sustainabilit issues are more accuratel priced intotheir investment decisions, to ensure that such issues areembedded at a corporate board level. Asset managersthemselves admit that the short-term investment culture in

which the operate is one barrier to integrating issues suchas climate change more ull into investment decisions.

3. M mr cc r

l R, rcr r m, [email protected].


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The need or institutional investors to exercise responsibleownership and extend their investment horizons isbecoming an accepted part o mainstream discourse oninvestment. The nancial crisis brought with it strongcondemnation rom some quarters o the role plaed binstitutional investors. Described as acting like absenteelandlords b the then Cit Minister, Lord Mners,institutional investors aced calls to behave as ownersrather than traders. The subsequent Walker Review(HMTreasur 2009) stated that those who have signicantrights o ownership and enjo the ver material advantageo limited liabilit should see these as complemented b adut o stewardship.

Following recommendations in the Walker Review, in Jul2010 the Financial Reporting Council published the UKStewardship Code or UK institutional investors aimedprimaril at asset managers, with the intention oenhancing the qualit o engagement between

institutional investors and companies (Financial ReportingCouncil 2010). yet environmental and social issues havebeen strangel absent rom the stewardship agenda.Despite the closer ocus on governance issues,engagement on environmental and social risks is stillregarded as an optional extra b man investors and theirregulators. The UK Stewardship Code itsel barel mentionsengagement on environmental and social issues. Thepractical eect o this sidelining is signicant.Shareholders willingness to exercise their inuence inrelation to strictl nancial matters does appear to be onthe rise one recent example being the reversal b thePrudential board o takeover plans ater public and privateintervention b investors opposed to the plans. yet therewas a marked reluctance on the part o large UKinstitutional investors to support shareholder resolutionsled at BP and Shell in 2010 that ocused on their highlcontentious Canadian oil sands operations. I investors areto ensure eective integration o ESG issues at a corporatelevel, such issues must be an essential eature o theirstewardship activities and it ma be necessar or utureversions o the Stewardship Code to make this explicit. Incontrast to the UK Stewardship Code, the Drat Code orResponsible Investing by Institutional Investors in South

Arica (Committee on Responsible Investing b InstitutionalInvestors in South Arica 2010) makes explicit reerence tothe need or incorporating ESG issues into investment

analsis and activities.

iMPRoved naRRative RePoRting

I enlightened shareholder value is to be relied upon as amechanism or ensuring that companies integrate ESGissues ull into strategic decision making, then companreporting requirements must ensure disclosure o allmaterial risks: not least, material environmental and socialrisks. Onl then will investors be able to integrate thoserisks into investment decisions and engagement activitiesin a meaningul wa. More robust reporting requirementsneed not mean additional burdens on business. Indeed,the reverse ma be true: one o the problems with socialand environmental reporting at present is the prolierationo length reports o little use to investors, in which kestrategic issues are either masked, or ignored entirel.

As noted in a recent ACCA publication, reporting not onlhas the benet o communicating inormation toshareholders and other stakeholders but helps the

preparers o the reports b ocusing their minds (ACCA2010). An improved reporting regime or social andenvironmental issues would lead both investors andcompanies to consider such issues in more detail. Poorstandards o reporting raise concerns that actual risk-management practices mirror the deciencies in narrativereports.

This is well-illustrated b the recent independentsubmission b Client Earth o Rio Tintos 2008 annualreport to the Financial Reporting Review Panel (FRRP)(Client Earth 2008). In this case, the compan makesgeneral positive statements about the importance oenvironmental and social responsibilit, but ails tomention numerous specic material issues with strategicimplications, including the decision o a major shareholderto divest on environmental grounds, and the reputationaland litigation risks associated with specic mining projects.

There is currentl a lacuna in business reporting onenvironmental and social risks. Rather than integratingspecic inormation on ke ESG business risks into theirdepiction o the compans business and strateg, mancompanies narrative reports make vague, boiler-platestatements to the eect that the take environmental andsocial issues seriousl. All too oten, environmental andsocial issues are instead consigned to backward-looking

CSR or sustainabilit reports with detail provided oncontributions to the local communit and in-oceenvironmental programmes. Such reporting cansometimes seem more like a public relations exercise than


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3. MAKING BUSINESSES MORE ACCOUNTABLE TO INVESTORSRISK AND REWARD: SHARED PERSPECTIVES 17

a balanced overview o business risks, and presents aninappropriatel positive view o the compan. In ourexperience, inormation provided to investors incompanies narrative reports is inadequate to enable themto press directors on material environmental and socialrisks acing the business. B contrast companies auditedaccounts generall allow investors to take a view on kenancial risks. This is because audited accounts havecharacteristics such as comparabilit and veriabilit,which we believe are now also necessar or reporting onenvironmental and social risks.

One o the greatest environmental risks acing companiesis climate change. In FairPensions 2009 surve o thepractices o UK asset managers in relation to climatechange, almost two-thirds o respondents cited poor-qualit compan data on greenhouse gas emissions as abarrier to greater integration o climate change risks intoinvestment decisions. Most respondents (86%) said that

the would welcome requirements on companies to reporttheir emissions, while 78% would welcome stock exchangelisting rules that required companies to disclose theirclimate-related risks.

In this context, the inclusion in the UK governmentspublication The Coalition: Our Programme or Governmento a commitment to reintroduce an Operating andFinancial Review is particularl welcome. It is hoped that arobust reporting ramework emerges rom thiscommitment that will enable investors to incorporate ESGissues more ull into investment activit and thereb driveintegration o such issues into corporate decision making.

the investMent Chain

I compan CEOs are waiting to take their cue or actionrom institutional investors, then und managers, in turn,are waiting or large clients to request the integration oenvironmental and social issues into investment decisions.In FairPensions 2009 surve, 56% o respondent assetmanagers cited a lack o client demand as a barrier tomanaging climate change risks and opportunities(FairPensions 2009). Pension unds have an important roleto pla in ensuring that environmental and social issuesare integrated into corporate decision making. In itsimplementation document on the UK Stewardship Code,

the FRC highlights the importance o pension unds bothspecicall mandating asset managers to engage withcompanies on their behal and careull scrutinising theirreports on engagement. Despite this, it is disappointing

that within the Code the FRC did not set out stewardshipprinciples or asset owners such as pension unds, giventheir ke role within the investment chain.

2010 marked the tenth anniversar o regulationsrequiring UK pension unds to disclose the extent (i an)to which environmental, social and ethical considerationsare taken into account in making their investmentdecisions. Over this period, increasing numbers ooccupational pension unds have included in theirStatements o Investment Principles (SIPS) conrmationthat ESG issues are taken into account to the extent thatthe are nanciall relevant, without providing an greaterspecicit. But is this broad polic commitment leading toconcrete action to manage such risks? Recent researchconrms that man UK pension unds are not taking stepsto ensure that their asset managers adequatel monitorESG risks. FairPensions most recent surve (FairPensions2009) o large occupational pension schemes in the UK

ound that, despite universall acknowledging theimportance o ESG issues in their SIPs:

35% o participating schemes did not integrate theirESG polic into investment management agreementswith asset managers

30% did not,as part o the und manager selectionprocess, assess the abilit o asset managers tomanage ESG risks

35% did not require regular reporting rom assetmanagers on what is being done to manage ESG risks.

So what, then, will secure urther action rom asset ownersto drive environmental and social risk managementthrough the investment chain right to the boardroom door?A ke part o FairPensions work is to educate andempower individual pension savers to ask questions otheir pension providers and to make their preerencesknown with regard to the consideration o ESG issues inpension investment decisions. At the present time,individual pension savers are ill served b a regulatorsstem that allows a lack o transparenc andaccountabilit in the implementation b pension providerso the boilerplate polic statements reerred to above.Greater transparenc, achieved through requiring pension

unds to report on how the have implemented their policon ESG issues and their voting polic, would, we believe,lead to consumer scrutin o, and demand or, engagementon ESG issues.


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ConClusion

For too man companies consideration o ESG issues islimited to activities ocused on operational cost reductionand reputation enhancement rather than the identication

and management o material business risks. Recent eventshave highlighted the necessit or a change in thesepractices. Change will require action rom all participantsin the investment chain. Regulators must enable thisaction through initiatives such as the introduction o arobust operating and nancial review that ensures theprovision o orward-looking strategic disclosures on allmaterial risks, including environmental and social risks.Institutional investors must scrutinise and use suchdisclosures to engage eectivel with companies on ESGissues and demonstrate transparentl to their asset-ownerclients and ultimate beneciaries that the are dealing withESG risks. Environmental and social issues must be placedat the heart o investor stewardship b both investors and

regulators. And the general public, whose savings areinvested in companies, must become more engaged withtheir mone managers and express their preerences oraction on environmental and social issues. Greateraccountabilit to the ultimate beneciaries would beacilitated b the introduction o updated regulationsrequiring pension providers to report to pension savers onthe integration o ESG decisions into investment decisions.Environmental and social issues must take their place atthe heart o investor and corporate decision making sothat companies, investors and individual savers will be in abetter position to prevent or at least mitigate an uturenanciall devastating events such as the banking crisis

and the Gul o Mexico oil spill.


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4. LEARNING FROM ENVIRONMENTAL CREDIT RISK MANAGEMENTRISK AND REWARD: SHARED PERSPECTIVES 19

The risk-management practices o the banking sector havebeen a ocus o attention in evaluating both the causes andsolutions to the recent nancial crisis. With claims that thecrisis was caused b an increase in sub-prime lending inthe US propert market leading to write-downs o thebanks loan books, dramatic rises in lending interest ratesand the eventual breakdown o interbank lending thebanks have been characterised b poor risk management,overreliance on propert valuation, and a need or change.Nonetheless, there is an enduring positive trend within riskmanagement in the banking sector that can give us causeor optimism environmental credit risk management(ECRM) and, in particular, developments in climate riskmanagement.

For a number o decades now, banks have engaged inECRM to protect themselves rom the materialenvironmental risk primaril associated with commerciallending activities. Concern about environmental credit risk

has been driven initiall b potential lender liabilitassociated with securit ownership and a bankscontrolling inuence over a compan to which it is lending.Arguabl, i banks are perceived to exert such power as toinuence a borrowers operational management then theshould be held liable or the impact o the borrower on theenvironment and share clean-up responsibilit. In practice,however, contamination ma be historical and not the aulto the borrower or the bank. Thus, while banks have beencareul to operate at arms length rom their borrowers,the have aced the challenge o reling upon real estateasset valuations while uncertain about the potential impacto environmental degradation o those sites. This iscoupled with a banks assessment and management o therisk to loan repament that arises when a borrowerscash-generating abilit is subject to a potential liabilit orclean-up costs and the prospect o shortalls on assetvaluations in the event o oreclosure.

aCCounting and the Challenges oFenviRonMental Risks

The accounting challenges posed b environmental risksare not necessaril all monetised or even quantiable butthe require recognition and management. Delivering apresentation to an accounting and risk class at theUniversit o Strathclde in 2010, Chris Bra, head oenvironmental risk management with Barclas, elaboratedon this challenge. His position is that the environmentalrisks that he manages are usuall qualitative and notquantitative.

Theres not necessaril an linear scalabilit in the riskrelationship, oten theres no cap on some environmentalliabilities sometimes there ma be but more oten theresnot, and the liabilit or reputational risk to a bank throughassociation with clients showing poor environmentalmanagement can be disproportionate to the level o debt

oered it can be a real problem assessing the magnitudeo risks o this nature.

There is much that accountants can learn rom theenvironmental valuation debate within environmentalcredit risk management over the last ew decades, inparticular with respect to the use value o nancial andnon-nancial inormation.

CliMate Change Risk

One o the criticisms o the nancial sector during thenancial crisis has been that banks have ailed to considersstemic risk: in designing products and risk-managementprocedures the have not thought about the impact otheir actions on the market as a whole. This is not the casewith ECRM and climate risk. At the moment there are anumber o initiatives in the market to raise the bar oECRM across the global banking sector and ensure aminimum standard is operated or ECRM, so it isbecoming more dicult or dirt companies to shoparound and nd nance.

Take the example o the Equator Principles1 or projectnance. Banks have adopted internationall recognisedenvironmental and social management standards bdrawing on guidelines and indicators developed b the

International Finance Corporation to provide a legitimate

1. A benchmark developed b the nance industr or determining,

assessing and managing social and environmental risk in project nancing.

4. lr rm rm cr r mm

dr ar b. C, r crr cc, ur src cr aCCa [email protected].


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model or risk assessment. Although commitment to theEquator Principles remains voluntar, ew sndicates areled b non-Equator banks. When credit alls outside thescope o the Equator Principles there is an increasingexpectation than Equator standards will inuence generalECRM practice.

Eorts to raise lending standards across the bankingsector are exemplied toda b the mounting challenges oclimate change. A brieng paper designed b Barclas, incollaboration with climate risk management specialistsAcclimatise, highlights the potential material environmentalrisk (and opportunities) posed b changing weatherpatterns and associated phsical impacts. The reportCredit Risk Impacts o a Changing Climate (Bra et al. 2007)highlights current eorts within the banking sector tocollaborate and encourage good practice. The targetaudiences in this instance are lenders and borrowersengaged in sectors dependent on substantial xed assets

and inrastructure, as well as the energ, chemicals,pharmaceuticals and tourism sectors. Advising on genericactions or climate-risk management, the report sharesBarclas experience o identiing climate sensitivities andcritical thresholds or management in each sector. Thisincludes advice on understanding and monitoring theposition o external stakeholders, evaluating the supplchain, assets, operations and processes vulnerable toclimate risk, and using mechanisms or managing nancialrisk, including insurance, to manage climate risk.

Arguabl, what is restricting the development andstandardisation o ECRM is the availabilit o appropriateinormation. In the light o suggestions that the nextnancial crisis ma be based on climate risk we can expectthese kinds o risk to prolierate in the uture. The resultso a global surve o the climate change inormationrequirements o the nancial sector, conducted b theSustainable Business Institute with the United NationsEnvironment Programme Finance Initiative (2011),Advancing Adaptation through Climate Inormation Services,

highlights this problem. The authors advise that: adaptingto climate change boils down to identiing, quantiing,pricing, and mitigating the nancial risks linked with

climate change impacts. Integration o climate changeinormation and assessment o environmental risks withnancial inormation is needed to enhance nancialinterpretations and contribute to transparent asset andliabilit valuations. Accountants have a pivotal role to plain acilitating this change and ensuring nance is availableor uture economic growth and a movement beond alow-carbon econom.

the Role oF aCCountants

The banks reaction to environmental risk has dependedon exibilit and creativit in order to come up withsolutions. This illustrates that in the current nancial crisisregulation and controls are not necessaril the solutions inever instance, at least until we have developedappropriate tools and standards to ensure clarit andadequate inormation is orthcoming that is suitable orpurpose. From both a lender and a borrower perspective, a

ocus is needed on management sstems and nancialengagement involving accountants. In m experience weneed a transparent, innovative solution to nancing thathighlights a shared perception o risk valuation, negotiatedthrough stakeholder consultation and accounting expertiseto ensure that inormation is available to help in makingthese investment decisions.


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intRoduCtion

Stories o corruption, raud or wider business ethics issuesare rarel out o the news. Ever ear has its crop ounwelcome headline scandals, oten implicating householdcorporate names or their sta in practices that damagereputations and send share prices plummeting.Corruption, that is the abuse o entrusted power orprivate gain (Transparenc International 2011), is aparticular ocus o UK companies in 2011 as the UKBriber Act comes into orce and the Serious Fraud Oce(SFO) is talking publicl about the added resources it willbring to bear to prosecute UK and international companiesthat all oul o the new law. Identiing and evaluating therisk that corruption or raud will have a material impact oncompanies represents a real challenge or investors. At theextreme, such issues can have a catastrophic impact onshare prices, as the ailures at Enron, Worldcom andParmalat demonstrate, and recent regulator action and

litigation in the US and German have resulted in nes inthe hundreds o millions o dollars.

Collateral long-term damage to brand and competitiveedge also extends beond the core issues o raud andcorruption and into wider business ethics issues. In recentears, companies shown to have unscrupulous businesspractices, poor working conditions or emploees orsuppliers and/or poor environmental practices have ound

that their broader reputation has suered, underminingtheir share price in the short term and their abilit tooutperorm their peers over the longer term bdiscouraging talented sta, customers and suppliers romworking with the organisation. I anthing, the response onancial markets to business ethics issues is likel tobecome more pronounced as governments around theworld continue to reinorce sanctions on businesses thatare ound to have been guilt o poor ethical practices.

5. a r-rp: r r m

c rs b, sRi rrc, hr g ir, [email protected] ar, rcr, Frc src, PC, [email protected]

t 5.1: sfc us uk crpr crrp p 2010

Year Company IndustryDOJ criminal penalties

(millions)

SEC civil penalties

(millions)

SFO settlements

(millions)

2010Technip and

Snamprogetti

Construction and oil

eld services$240.0 $125

2010 Daimler Automotive $93.6$91

(disgorged prots)

2010 Innospec Chemicals $41.1 $11.2 $12.7

2010 BAE Sstems Deense $400 N/A 30

b 5.1: C : sm

The corruption scandal at Siemens is perhaps the highest-prole corporate corruption scandal in recent ears and aardstick or the eect o business ethics problems on amodern business. The US cases against the compan were

settled in 2008 ater the judge accepted guilt pleas romSiemens lawers over a slush und totalling more than1.3billion that was used to win overseas contracts rom2001 to 2007. The scandal has cost Siemens, a smbol oGerman engineering excellence and corporate probit, notonl its reputation and that o ormer senior executives butmore than 3billion in nes and costs.

5. AVOIDING BEAR-TRAPS: AN INVESTOR TOOL FOR

IDENTIFyING AND MANAGING BUSINESS ETHICS RISKS


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The problem acing investors is not so much a question owhether or not these issues matter, but how investors canboth spot companies that are particularl vulnerable tounethical practices and adopt investment strategies thatensure that the are not negativel aected b thosepractices. Addressing this problem was the ocus o aresearch project in 2009 undertaken b Henderson GlobalInvestors and PwC. The project raised the ollowingquestions.

How can one identi companies with a greater risk ounethical and/or illegal business practices and arethere common risk characteristics and indicators?

What reassurance should one look or in morevulnerable companies (ie what questions can one askmanagement about policies, sstems, perormance andpractices)? What does good business ethics risk-management practice look like?

While rameworks have been developed b investors andothers that ocus on assessing the qualit o governance obusiness ethics and compliance, our objective was to gourther and develop a ramework or identiing bothvulnerabilit to business ethics risks and the speciccharacteristics o best practices or managing these risks.

business ethiCs as an investMent Risk

We regard business ethics as a orm o applied ethics thatrelates to ethical principles and moral or ethical problemsthat arise in a business environment. For our purposes, inrelating this back to a nancial investment proposition, wewere most interested in ocusing on those unethicalpractices that are likel to have the largest impact on theshare price perormance o listed companies. This couldbe as a result o legal action or government intervention,reputational damage and/or another threat to the long-term existence or stabilit o the compan. Although werecognise that there is a much wider business ethicsagenda, we nonetheless dened the scope o businessethics or our purposes as relating to the broad issuesdened in the Box 5.2.

Another ke consideration or the project team was thepotential materialit o the business ethics risk.

Materialit actors considered were whether the risk couldreasonabl be oreseen as resulting in at least two o:

legal action or government intervention

threat to long-term existence/stabilit

reputational damage.

Fr: 5.1: t r r

Note: Materialit actors considered were whether the risk could

reasonabl be oreseen as resulting in at least two o: legal action/

government intervention, reputational damage, and threats to

long-term stabilit or existence.

Legal action or

government

intervention

Reputational

damage

Threat to

long-term

existance/stabilit

!Material business

ethics risk


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Rogue trading/dealing/investment schemes: raud thatresults rom emploees actions that contravene industr andcompan rules and regulations, including Ponzi schemes, and

rom manipulating workplace controls.

Public sector corruption and briber: where bribes areoered to government ocials to win or retain business, or toachieve some other commercial advantage, eg obtaininglicences and planning consents.

Briber and corruption: the abuse o public oce or privategain, including unilateral misconduct b government ocials,such as embezzlement and nepotism.

Private sector corruption and briber: the provision oimproper benet (in cash or kind) to customers, agents,contractors, suppliers and reciprocal benets to emploeesor encouraging violating behaviour in subsidiaries.

Unscrupulous business practices: such as overcharging,marketing to sociall disadvantaged or vulnerable customergroups and aggressive debt-collection methods.

Fraudulent borrowing or lending: such as putting intensepressure on companies seeking to extend credit lines.

Cartel raud: collusion b rms or nations to attempt tocontrol the price or suppl o a commodit through mutualrestraint on production.

Mone laundering: the processes b which criminals attemptto conceal the true origin and ownership o the proceeds ocriminal activities. Mone-launderers will tr to use legitimatebusinesses to clean their unds.

Insider dealing: dealing or an attempt to deal, b an insider,in an investment on the basis o inside inormation in relationto the investment.

Market abuse: misusing inormation, creating a alse ormisleading impression, and/or distorting the market bmanipulating prices .

Fraudulent misrepresentation: an instance o alse statement,including omissions or disclosures intended to deceive, wherethe part making the statement is aware that it is alse ordisregards the possibilit o it s being alse. It o ten involvescollusion with third parties to misrepresent nancialinormation and statements deliberatel.

Environmental accountabilit: liabilit or remediation andoperational compliance breaches rom water pollution, landpollution and waste, air pollution and depletion o naturalresources.

Social accountabilit: human rights abuses occur in almostall contexts and countries. Low-skilled and labour-intensivesectors pose the most acute risks, especiall oil/gas, mining,inrastructure/construction, deence, pharmaceuticals/healthcare, tourism, orestr/agriculture, manuacturing/consumer suppl chains (eg textiles and clothing).

b 5.2: M cmm -mpc -c r




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identiFying Red-Flag Risk indiCatoRs

The core o the ramework ocuses on a list o red ags,which relate to specic business characteristics that havehistoricall been linked to a high incidence o materialbusiness ethics issues. Through an in-depth assessment oover 40 business ethics case studies we identied over 50red ags, which were grouped into ve broad categories:

tpe o industr

countr o operation

compan structure and business model

management integrit and supervision

high-level nancial indicators.

In reviewing the case studies we also made the ollowingobservations.

The number o indicators present or each case wassignicantl higher in cases that threatened the long-term viabilit o the compan.

There was overlap between some indicators, but it wasthe number o indicators present or each case thatwas o ke importance, rather than the specicimportance o particular indicators.

Management integrit and supervision, and nancialindicators were more important in catastrophic cases(those resulting in the destruction o the compan).

Limited availabilit o public inormation (eg nancialdata) made some indicators dicult to assess.

Ultimatel, o the 50 red ags identied in the review oprior cases, we short-listed 18 that we considered to bemeasurable, objective and time-restricted. These red agsidenti whether a business characteristics and operatingenvironment expose it to greater business ethics risk. Inthemselves, the red ags do not, however, mean that aparticular compan is necessaril more likel to be subjectto business ethics malpractice, as it ma manage those

risks eectivel. In order to determine whether an givencompan is indeed more likel to be subject to businessethics malpractice we thereore needed to engage directlwith management to understand the qualit o their

internal control sstems or managing the vulnerabilitiesthat we identied. This two-stage risk-assessment sstemis summarised in Figure 5.2 below.

Having developed the ramework, we then pilot tested alive portolio o companies held in one o Hendersons UKunds. The portolio was composed o over 100 companiesbut we narrowed the assessment to ocus on theapproximatel 40 companies where the und had anoverweight position against the index. The 40 companiesvaried widel and were rom a variet o industr sectorsand sizes.

O these 40 companies, 11 companies registered six ormore red ags, 11 had between three and ve and theremainder had ewer than three. From the companies thatregistered six or more red ags we selected ve to engagewith directl to obtain a better understanding o their

internal control sstems or managing the vulnerabilitieswe had identied. Table 5.2 summarises the ke issues atthe dierent companies and the 18 indicators we used tomeasure vulnerabilit to business ethics risks.

Fr 5.2: t- r m m

Indicator risk assessment

18 leading indicators o business ethics risk.

Grading sstem: 3 indicators or less = lower risk;

45 = medium risk; 6 or more = higher

Questionnaire and interview

On issues identied b indicators and wider riskand compliance management ramework.

Final confdence assessment


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Figure5.3:Portfoliocompanieswithhighle

velsofvulnerabilitytobusinesseth

icsrisks

TypeoIndustry

Countryo

operation

Companystruc

tureandbusinessmodel

M

anagementintegrityand

su

pervision

Highlevelfnancial

indicators

Company

Industry

operates

usinglarge

amountso

cash

Industryhas

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useo

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CompanyA:

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medical

equipment

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*SEE=socia

l,e

thicalorenvironmental




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26

CoMPany engageMent

The second stage o the process was to meetrepresentatives o each o the companies that we hadidentied as being vulnerable to business ethicsmalpractice. We made clear in our communication withthe companies that our risk assessment tool had simplidentied them as being vulnerable, but that this was in nowa intended to determine the existence or not o anmalpractice. O the ve companies that we wrote to, ourultimatel agreed to meet with us the th released astatement soon ater we wrote to them indicating that themanagement had uncovered an extensive nancial raudin one o the compans subsidiaries and would thereorenot be able to discuss these issues separatel with us.

The ocus o the engagement was to explore the qualitand depth o the control sstems that each compan hadin place to manage the red-ag issues that we had

uncovered. Although the project included onl one meetingwith each compan, we were able to make several kepreliminar ndings rom this process.

The responsiveness o compan management to ourengagement was a strong indicator o the qualit o thesstems the compan had in place (ie the moreresponsive the compan, the higher the qualit o thesstems).

Although most o the companies had clear policies inplace to manage the relevant issues, there was amarked dierence in the level o additional detail thewere able to provide about the experiences the hadhad in implementing the policies.

Similarl, some respondents were able to tell acompelling stor o risk management, while othersdescribed their experience as a journe or had notgrasped the importance o the issue.

Overall, governance rameworks were a less valuableindicator, with most companies reporting senior-levelleadership o ke risk or the existence o ethicscommittees though in onl the most advancedcompanies was there a link to remuneration or otherincentive structure.

The qualit and extent o reporting was also a kedierentiator. For example, the more advancedcompanies were able to provide both detailedanecdotes as well as quantitative data on theperormance o their internal control sstems. In somecases companies were also reporting this publicl,through either their annual or corporate responsibilitreports.

ConClusions

There is no doubt that changes in businesses operatingenvironment (eg regulator change) are increasing risk inthe area o business ethics to companies and thereore toinvestors. Indeed, a 2010 surve conducted b PwC onbusiness ethics and Tone-rom-the-Top activit withincompanies, ound that 70% o respondents agreed orstrongl agreed that ethical risks are identied but onl34% report the are adequatel measured or evaluated,

while 27% conrmed that their business had recentlterminated a business relationship as a response tounethical behaviour (PwC 2010). Though the tooldeveloped did identi the one compan o over 50 in theportolio to suer a serious business ethics issue last ear,it is too earl to comment on its overall eectiveness. Whileman o these risk indicators themselves are unlikel tobe new to portolio managers, the value we have ound isin incorporating them into a disciplined and structuredramework to help assess business ethics risks. Theramework can be applied at both portolio level (but withsignicant resource requirement and existing knowledgeor large numbers o stocks) and on a stock-b-stockanalsis basis (eg or initial public oerings (IPOs), and newentrants to the portolio).

The research on which this article is based wasundertaken as part o Hendersons commitment toresponsible investment practices and was supported bHendersons Responsible Investment Committee.


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intRoduCtion

Common sense might tell ou that good ethicalmanagement will be reected in strong organisationalperormance. In this chapter we explore whether ethicalgovernance actuall leads to better organisationalperormance, in particular whether or not we can establisha link at all.

There are man denitions or ethical governance, but it isgenerall accepted that it includes values such as integrit,airness and respect, values that are driven borganisations through rameworks, rules and codes (ACCA2010). For the purposes o this paper, I have situatedethical governance within the wider denition ogovernance: ensuring the organisation is doing the rightthings, in the right wa, or the right people, in a timel,inclusive, open, honest and accountable manner (AuditCommission 2009). This is because, like the Audit

Commission (England), I believe that ethics are inseparablerom governance as a whole. Thereore, I will be reerringmore widel to governance throughout this chapter.

does good goveRnanCe lead to betteRoRganisational PeRFoRManCe?

More oten than not, organisations choose to make the linkbetween governance and organisational perormancewhether or not there is an evidence to support it. It easilslides o the tongue, or example, good governanceimproves service perormance or strong governanceleads to better qualit services (Bundred 2007). It isassumed that there is a direct and clear causal linkbetween eective governance and the perormance o anorganisation in increased protabilit, more eectiveservice outcomes and improved reputation. In realit,however, the link to organisational perormance is rarelstrong. James Lockhart, a leading academic in this eld,believes that ater two decades o governance research[w]e are little the wiser in determining whether or notthere is some relationship between governance and theorganisations perormance (Lockhart 2006).

The correlation between eective governance andimproved organisational perormance has been exploredin both the public and private sectors. Studies examining

the links between changes in governance andperormance, particularl relating to the public sector, areparticularl scarce, and in some cases the evidence

appears questionable. Studies have examined whetherthere are links between dierent tpes o governancearrangements and organisational perormance and haveconcluded that it is dicult to conclude that there are(Skelcher and Mathur 2004), and that, attempts tocorrelate board structures and perormance were o littleoperational value (Cadbur 2002).

In addition, a number o empirical studies have tested thelink between reorm o governance arrangements andchanges or improvements in organisational perormance.For example, Skelcher and Mathur tested the hpothesisthat institutional economics-inspired theor, which hasunderpinned much recent public management reorm,predicts improvements in organisational perormancewhere an entit gains greater autonom rom politiciansand greater engagement with market orces (Skelcher andMathur 2004). The authors conclude that the theoreticalconnections between governance arrangements and

organisational perormance are poorl supported b theevidence. In act, at the time o their research it was easierto establish the implications o governance arrangementsor democratic perormance than or organisationalperormance. Also, Jobome suggests that good governancedoes not necessaril impl higher perormance privatesector-stle governance arrangements do not alwaspredicate high perormance (Jobome 2006).

Overall, the literature shows that it is easier to make thelink between governance and public trust and condence.Rowson (2006), or instance, discusses how an ethicalramework can enable proessionals to work moreeectivel, earn trust, mutual support and respect, andoster democratic ideals. He argues that despitedierences between proessionals, there are certaincommon core values that, i accepted and acknowledgedb ever proession, could help each be more eective andcould also enhance cooperation between them.

The authors o an Audit Commission report (2003),Corporate Governance: Improvement and Trust in Local

Public Services, also note that although there is evidence tosuggest that inappropriate behaviour can damage publiccondence, the link between perormance and ethicalbehaviour is less clear: High perorming councils asmeasured through Comprehensive Perormance

Assessment (CPA) can displa poor ethical standards,and that some poorl perorming councils have highethical standards (Audit Commission 2003).

6. ec: c rc c r r

prrmc?g Fc, pc cr, [email protected]

6. ETHICS: DOES ETHICAL GOVERNANCE ACTUALLy LEAD

TO BETTER ORGANISATIONAL PERFORMANCE?


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28

Nonetheless, it has been demonstrated that certainaspects o governance can be associated with greaterecienc. For example, government unding (externalgovernance) is associated with high pass-throughecienc because o the eectiveness o the reporting andmonitoring mechanisms that accompan such unding. Itwas concluded rom research b the Audit Commission(2003) that ecienc benets can be gained rom use ointernal or external devices which strengthen reportingmechanisms and restrict managerial discretion.

An extensive worldwide surve carried out b McKinseand Compan (2002) ound compelling evidence tosuggest that investors will pa a premium or companieswith high governance standards. Premiums averagedbetween 20% and 35% in Asian countries. This is anindication that well-governed organisations will perormbetter in the stock market. In addition, in a stud o morethan 5,200 rms in the US, Aggarwal (2007) looked at 64

governance attributes and ound a positive and statisticallsignicant relationship between governance and rmvalue.

PooR goveRnanCe is MoRe easily linked tooRganisational FailuRes

Nonetheless, it is perhaps easier to turn the debate on theimpact o governance on its head b making the linkbetween ineective organisational perormance andgovernance. This would seem appropriate because o thecatalogue o organisational ailures and evidence to drawupon. I strongl believe that at the heart o everorganisational ailure is poor governance and ethicalbehaviour. High-prole corporate ailures underpinned bpoor ethical standards o behaviour and/or sleaze havebrought ethical governance into sharp ocus in both theprivate and public sectors. Larr Scanlan, President andCOO o the Hunter Group (US), summed this up succinctl:Ive never seen a distressed organisation that could not betraced back to ineective governance (Scanlan 2010).

Most recentl, serious aws and shortcomings ingovernance have been identied with the banks. Thenon-executive oversight o bank executives ell short andhas brought governance issues back in the public ee(House o Commons Treasur Committee 2009). Prior tothis there was a wave o scandals, including Enron andMaxwell. In the public sector there have also been anumber o high-prole service ailures.

In the public sector, ailures in service perormance haveoten resulted rom ailures in governance. For example, in

Jul 2006 the Audit Commission reported that weaknessesin governance had been a ke actor in the nancialmeltdown o a number o NHS trusts (Audit Commission2006). A recent report into the governance o DoncasterMetropolitan Borough revealed that over a period o 15ears there had been a spate o instances o poor ethicalbehaviour that had resulted in poor service outcomes orcitizens: The Council, and ke councillors within it, are not

working constructivel with the Maor or with partners toachieve better outcomes or the people o Doncaster.Some inuential councillors place their antagonismtowards the Maor and Maoral sstem, and theachievements o their political objectives, above the needso the people o Doncaster, and their dut to lead thecontinuous improvement o services (Audit Commission2010).

The adoption o a perormance culture in public serviceshas led in some cases to unintended governanceconsequences. The pressure to hit targets has led toddling gures, phantom placement scams and doublecounting in the case o meeting emploment targets(Lawton 1998). In local government there was the exampleo postal vote irregularities b councillors prior to two localcouncil elections in Birmingham. Fawcett and Wardmanalso have also drawn attention to the Bristol RoalInrmar Inquir (2001) and the Climbli Inquir (2003)as revealing urther examples o poor governance (Fawcettand Wardman 2008). In all these cases it is all too eas toidenti the actors and ailures that contribute to ailureater the event.


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going FoRwaRd

So where do we go rom here? There is substantialevidence to suggest that governance can aect public trustand accountabilit. It would appear to be common sensethat good governance is linked to eective perormance: idemonstrable links to poor perormance can be madethen there is surel a case or making a link. In the highereducation sector, or example, Bader (2001) identies ourtangible was in which governing bodies can add value inthe n

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