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Open letter – In response to Consultation Document Proposal for an Initiative on Sustainable Corporate Governance

Open letter to European Commission, directorate general for justice and consumers, A3 company law

For the attention of Ms. M. Laurila, Ms. S. Knoefel, Ms. Z. Kerecsen and Mr. J. Gomez-Riesco

The Hague, 5th of February 2021

The Commission deserves full credit for its ambition to make Europe the world’s first climate-neutral continent by 2050. In line with the European Green Deal, amendments are also proposed to the corporate governance framework. Long-term sustainable development requires businesses to make stakeholder-inclusive decisions in support of a regenerative economy. Such corporate responsibilities require clarity on directors’ duties and supply chain due diligence in support of creating long-term societal wellbeing on a healthy planet. The Commission’s sustainable corporate governance initiative could serve as a much-needed catalyst for the economic transition if structured carefully and with a soft implementation approach.  This hybrid model would combine best practices in an “apply and explain” format with a mandatory reporting and disclosure framework. By contrast, standardizing best practice in mandatory law may lead to a one-size-fits-all style of regulation, limiting corporations to adapt to change and further fostering a tick-the-box compliance mentality. In this letter, we outline our thinking in support of an effective and efficient sustainable corporate governance model that contributes to the needed change.

Reward Value is a non-profit research initiative. Reward Value can be reached by email (

1. Introduction

Societal concerns over challenges such as climate change, the decline in productivity and rising inequality have sparked increasing calls for public intervention. Policy makers and regulators have expressed the ambition to tackle such challenges through the formulation of policy agendas. Against this backdrop, there are widespread concerns over the role firms play in addressing these societal challenges. A long-standing debate centers on whether firms unduly sacrifice future value for high current profits, the extent to which corporate decision makers should consider stakeholder interests in setting firm strategy, and the responsibility that individual firms have for business practices throughout their respective value chains.

The European Commission’s consultation on Sustainable Corporate Governance reflects an ambition to address the abovementioned concerns about corporate behavior by intervening in the (internal) corporate governance of firms. The underlying theory of change is that corporate behavior (and therefore its externalities) can be changed by restructuring the decision-making process at firm-level.

2. Optimal public policy

From a welfare economic point of view, policy intervention is justified if it directly addresses market failures and/or safeguards non-economic public interests. This essentially constitutes a cost-benefit approach, in the sense that public intervention must increase social welfare and as effectively and efficiently as possible. If not, this would result in policy failure. The question then is whether internal corporate governance reform is the best approach to address issues such as climate change, rising inequality or the decline in productivity. In the area of climate change for instance, there is a demonstratable market failure in the form of numerous negative externalities. However, these are best addressed by an adequate pricing mechanism.[1]  It is fair to say, that corporate governance reform will in many cases not be the most efficient way to deal with climate change, even if it proves to be effective.

This is not to say that there is no scope for corporate governance reform. Where optimal public policies are not implemented, corporate governance reform may serve as a second-best solution. When optimal public policies are implemented, corporate governance that fosters long-term sustainable decision-making may be a supporting or even catalytic factor in translating optimal public policies and societal demands to appropriate firm behavior. Fit-for-purpose governance structures combined with guidance and reporting on socially desirable firm decision-making may give firms the tools to address societal challenges and empowers the market to better assess and value business decisions.

3. Effective corporate governance

Corporate governance regulation and policy has steadily increased over the years, revealing that not all interventions are equally effective and/or that there are often (adverse) side effects. Increased disclosure requirements have resulted in a ‘tick the box’ compliance mentality at many firms.  The cap on variable remuneration in the financial industry has resulted in some firms offering higher fixed salaries.  There is a risk that some of the sketched reforms in the EC’s consultation could be marred by similar issues. Amendments to the director’s duties may increase litigation risk; mandated engagement with stakeholders may turn into a purely ‘procedural’ compliance exercise; and limiting buy-backs may become a restraint against financial market efficiency. In short, there is a risk that a one-size-fits-all regulatory approach will be unfit-for-purpose (at least in some cases), that firms could be successful in dodging the intended effects, and that when firms are unable to dodge the measures, potential side-effects of the measures may limit their efficiency.  

We would like to stress that corporate governance policy and regulation can be very effective policy tools. The effectiveness of corporate governance regulation, however, critically hinges on the exact specification and implementation of policies. We remark that the consultation questionnaire suggests policy areas, topics and directions, without providing concrete and specific policy formulations. As a result, for some questions it is difficult to accurately value the Commission’s proposals and to offer comments beyond the notion that we support the Commission’s line-of-thinking, but also see risks if more fleshed out proposals turn out to be overly restrictive or prescriptive, not flexible enough to accommodate individual firm circumstances, or fail to take lessons learned (in practice and in academia) into account.

Governance policy measures that have been relatively effective in the past often share the feature that they leverage the best interests of shareholders. The first evidence on say-on-pay suggests that it has helped limit pay, especially at poor performing firms, and that this is as a result increasingly a type of say-on-performance[3].  Similarly, some of the more successful corporate governance changes have been those which are implemented voluntarily. Large companies like Shell have board-level committees focused on responsible business conduct, and a firm like Unilever is consulting its sustainability policy with shareholders at the AGM.  Voluntary arrangements provide flexibility and allow material interest stakeholders to be considered to the extent that there is a need for incorporating those interests[2].  Firms will not want to dodge such issues, but instead set up a framework that allows them to adequately address them. Again, this is why policies such as carbon taxes are so effective in addressing climate change: firms can choose an appropriate (value optimizing) course of action and associated decision-making process, subject to the fact that firms themselves bear all the costs of their actions. Relatedly, large institutional shareholders state that they deem sustainability an important topic in engagement, engage on ESG , and move funds in response to shocks to the salience of sustainability in investments[4].

4. The case for a hybrid approach

Hard prescriptive regulation may have side-effects that may limit regulatory efficiency. This may be welfare decreasing, especially given the fact that corporate governance reform in many cases is a second-best measure to achieve better societal outcomes. It is difficult to ex ante define what firm behavior is desirable (and in what cases) and to have that (regulatory) enforced without entering a highly litigated society. Instead, leveraging share- and stakeholder knowledge and stakes may help to direct firms’ attention to material ESG topics.  Regulation should facilitate such engagement, without prescriptively specifying appropriate behavior that will only turn into a ‘tick the box’ compliance exercise (but overshadowed by litigation risk).

A hybrid regulatory solution may then deliver the best results. Leave to the market what can be left to the market but set standards and offer guidance to facilitate engagement and transparency. Options available to this end are;

1.           Harmonize disclosures on a comparatively limited set of material non-financial topics. Align disclosures with demonstratable market failures and ensure that disclosures are appropriate to determine the impact of non-financials (instead of just measuring inputs or outputs). Ensure consistency with the work program of IFRS as well as other EU policy initiatives.  Safeguard the continuous adjustment and rebalancing of the disclosure framework.

2.           Develop reporting guidance on stakeholder engagement and interests. Bridge the gap between societal expectations of firm transparency and realized transparency, for instance by developing a European Corporate Governance Code with a apply-and-explain mechanism.  Monitor the quality of disclosure and reporting. Further investigate the costs and benefits of developing corporate governance structures and models that mandate the inclusion of stakeholder says, before codifying such rights into law.

3.           Foster corporate engagement by further developing say-on-pay practices to explicitly include a say-on-purpose and -performance.

4.           Drive pay reform by developing a reporting template to create more transparency. Require firms to explain in sufficient detail how remuneration practices and policies are consistent with long-term stakeholder value creation, and how board evaluation and pay are linked to purpose and performance. Monitor the quality of reporting and level of clarity as to offer further guidance on reporting when appropriate. Develop best practices or principles that relate purpose and performance to pay, including a firm-specific yet comparable yardstick, a pay mechanism that contracts long-term sustainable outcomes, as well as a governance model that ensures appropriate oversight. See our Green Paper for further thoughts on firm level pay reform.

5. Conclusion

Sustainable corporate governance also requires a long-term orientation. The EC strongly believes that many companies still focus too much on short-term financial gains and as such insufficiently focus on long-term sustainable value creation. Short-termism is an issue, maybe as a result of investor nearsightedness, but definitely as a result of poorly designed executive compensation. Additionally, whilst stakeholderism cannot necessarily be equated with long-termism, there may be a mismatch between societal and shareholder time preferences and/or sub-optimal long-term societal value creation due to market failures. The issues of corporate financial short-termism and societal long-term value creation (e.g., the need for climate action) thus may intersect. Corrective policy action is warranted to achieve societal first-best outcomes, but should avoid constraining investor behavior. Instead, policies targeted at facilitating and leveraging share- and stakeholder monitoring and voice, combined with executive remuneration reform seem more appropriate. A detailed background note on Managerial and Capital Market Short Termism can be found here.

We support the ambition of the Commission to make Europe the world’s first climate-neutral continent by 2050, and we believe that sustainable corporate governance can be a powerful catalyst in support of this major transition. The efficacy of revised corporate governance is best served in our opinion by means of a hybrid model, combining best practices in an “apply and explain” format with a mandatory reporting and disclosure framework. The mandatory reporting and disclosure framework will enable stakeholders (including shareholders) to assess companies’ decision-making, behavior and impact by means of uniform, transparent and pre-set disclosure formats. In an environment where companies retain entrepreneurial freedom and stakeholders have access to detailed material information, best practices will flourish and stimulate companies to act in the interest of society. Stricter legislation may be counterproductive to change effectiveness and may result in endless litigations only slowing the transformative economy down.

Of all the topics associated with short-termism, executive remuneration is the least contested. Establishing best practice principles and models as well as improving information accessibility through a stricter reporting and disclosure framework will be a valid contribution to long-term sustainable value creation. An alternative approach to executive remuneration is expressed in the Green Paper “Rewarding Stakeholder Long-Term Value Creation”, which can be accessed here.

We trust to have contributed to the important initiative of the Commission and are at the Commission disposal for further insights and support.


Reward Value Foundation

Frederic Barge

[1] See

[2] See e.g. Ferri & Maber (2013). Say on Pay Votes and CEO Compensation: Evidence from the UK. JF 17/2. and Correa & Lel (2018). Say on pay laws, executive compensation, pay slice, and firm valuation around the world. JFE 122/3. 

[3] See and cf. e.g. Khan, Serafeim & Yoon (2016). Corporate Sustainability: First Evidence on Materiality. AR 91/6.

[4] See amongst others Harzmark & Sussman (2019). Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows. JF 74/6. McCahery, Sautner & Starks (2016). Behind the Scenes: The Corporate Governance Preferences of Institutional Investors. JF 71/6. Krueger, Sautner & Starks (2020). The Importance of Climate Risks for Institutional Investors. RFS 33/3.