Why should the public at large bear the cost of correcting the detriments that business has inflicted on society to the benefit of its owners and managers? We have to tackle the real problem: the nature of corporations
Few people would have predicted in 2019 that three years later the EU would have proposed and enacted a raft of new regulations dictating the behaviour of business and investors across Europe. Even fewer would have predicted that we would be well on the way to establishing a new set of standards for reporting on the non-financial performance of firms across the world but that is exactly what the International Financial Reporting Standards seek to do.
This represents a profound change in the regulation of corporate and financial markets and will be as significant as the factory acts of the 19th century, the anti-trust legislation at the beginning of the 21st century, the introduction of financial reporting in the 1930s, and the regulation of utilities in the 1990s. It reflects an equally profound way in which we view the firm and its financing.
Why is this happening? The simple answer is that the traditional model of the firm is failing. It is failing to address the massive problems that we now realize it is creating. The traditional view of the firm is that it should have one and only one objective which, as the Nobel Prize-winning economist Milton Friedman famously described is “to increase its profits so long as it stays within the rules of the game, which is to say engages in open and free competition without deception or fraud”.
In other words, the best outcomes for society are achieved if business promotes its efficient operation for the benefit of its owners, its shareholders, subject to the demands imposed on it by the functioning of competitive markets.
That has been the approach we have followed precisely over the last 60 years[SF1] [CM2] since Friedman first made that statement in the form of a combination of corporate legislation that promoted “the success of the company for the benefit of its shareholders”, competition policy that addressed competitive market failures and abuses, and regulation of natural monopolies, such as the utilities, which prevented dominant firm abuse.
What was not anticipated is the consequential environmental, social, and human detriments that would result from this agenda. It is only during the last decade that we have come to understand the scale of the damage being done to the atmosphere and the natural world, and the degree of inequality and exclusion experienced by large segments of society.
What the proponents of the Washington Consensus (the reforms proposed for developing countries by Washington DC-based institutions) anticipated was that these detrimental outcomes should and would be addressed not by business and the private sector but by government and the public sector. However, that has not occurred and to date, the public sector has proven incapable of mobilizing the resources required to address the scale of the problems, for example in relation to climate change and its social as well as environmental impacts on especially developing countries and left-behind regions of the developed world.
The US approach is to treat the climate as just another portfolio risk for the firm that therefore requires disclosure like any other source of risk
Who Bears the Cost?
Furthermore, even if it could, there is understandable questioning of why it should. Why should the public at large bear the cost and burden of correcting the detriments that business has inflicted on society to the benefit of its owners and managers? There is a natural justice case for arguing that business should be responsible for cleaning up the mess it creates and not expect the rest of society to do the job for it.
There are three types of responses that have been proposed to resolve this. Firstly, make business more transparent about the impact its activities are having on others; secondly, stop it from doing things that are to the detriment of others; and thirdly, recognize that the problem is not only of the private sector’s causing but also of the rest of society, and the private sector cannot be expected to rectify the scale of the problem on its own.
Regarding the third area of public expenditure, while there have been differences in the approaches and emphasis of Europe in the Green Deal and the US in the Inflation Reduction Act, basically both represent massive increases in government expenditure to address climate-related problems.
It is in relation to the first and second areas that differences in approaches on the two sides of the Atlantic have been more pronounced. In the US the emphasis has been on transparency and disclosure of information that is relevant and material to portfolio decisions of investors. The approach of the Securities and Exchange Commission (SEC) in the US has been to require corporations to report on climate-related effects of their activities that are material to the risks incurred by investors.
The nature of those risks is most obviously the financial risks to investors’ portfolios but there is an argument for suggesting that they should relate to investors’ beneficial interests more generally. As Oliver Hart and Luigi Zingales have argued in their paper in the first issue of the University of Chicago Business Law Review (Summer, 2022) on “The New Corporate Governance”, to the extent that shareholders are concerned about the effects that corporations have on their own and others’ wellbeing, including that of the natural world, then they should report on the material impact that they have on these non-financial as well as financial risks.
Nevertheless, the focus in the US is on the consequence of corporate activities for the interests of and impacts on shareholders, not on other parties - other stakeholders - directly impacted by firms. In other words, the US approach to climate change is extrinsic in relation to the consequences for their owners of effects of firms on others, not intrinsic to the direct effects on those other parties in their own regard.
In essence, what the SEC approach does is to treat the climate as just another portfolio risk for the firm that therefore requires disclosure like any other source of risk to improve the information on which investors make decisions.
The European approach differs in three respects. The first is to require reporting on not just the extrinsic impact of climate-related risks on investors but also the intrinsic on those affected by them. The second is not to restrict reporting to just climate-related risks but also certain aspects regarding human and social issues, especially human rights. The third is not to limit interventions merely to disclosure and reporting but also to include regulation of corporate and investor activities.
A swathe of new directives has been and is in the process of being adopted by the EU and the European Parliament. It provides a framework for and implementation of a comprehensive system of reporting on and regulation of the activities of both firms and investors.
Some of the key aspects are: the European Union (EU) Taxonomy which lays out a framework for the avoidance of harm in relation to five environmental pillars and the delivery of benefits in relation to at least one; the Corporate Sustainability Reporting Directive (CSRD) which determines non-financial reporting requirements; the Corporate Sustainability Due Diligence Directive (CSDDD) that sets out the basis for avoidance of violation of human and environmental rights in companies’ supply chains; and the Sustainable Financial Disclosure Regulation (SFDR) which lays down the categorization of investment funds in relation to their exposure to environmental, social and governance risks and impacts.
The CSRD is the European equivalent of the SEC initiatives on disclosure, but it is broader in scope in incorporating social as well as environmental impacts and extending them beyond their extrinsic relevance to investors to the impact on other stakeholders affected by firms. It is therefore a “double materiality” approach to reporting as against a “single materiality” approach of the SEC.
The SFDR reflects this in the categorization of investment funds and the engagement of institutional investors with their corporate investments. Article 8 firms take account of environmental and social considerations in their investment decisions and engagement. However, this might be in the context of just extrinsic shareholder risk. Article 9 firms go beyond this in demonstrating a positive impact on some other parties.
But there is a still more significant distinction between the European and US approaches and that relates to the CSDDD. This moves beyond disclosure and reporting to regulation of corporate activities regarding the avoidance of detriments. It imposes an obligation on firms to identify, manage, mitigate, and rectify harms done in relation to the environment and human rights.
Furthermore, it incorporates not only harms done by firms themselves but also those arising in their supply chains. The scope of the obligations and whether they apply down- as well as upstream is the subject of current discussion. Nevertheless, if enacted, the CSDDD will be an extensive imposition of “do no harm” on European companies and investors, and those operating, selling, or investing in the EU.
The final initiative which is potentially global not just US or EU in scope is that of the International Financial Reporting Standards (IFRS) foundation in establishing an International Sustainable Standards Board (ISSB) to enhance international standards on non-financial reporting. It recently brought out its first sustainability standards, S1 and S2, which in essence state that financial sustainability disclosures demand that firms’ governance, strategy, processes, and performance identify, monitor, manage, and meet sustainability risks and opportunities. If accepted, it will provide an international framework within which the US single materiality and the EU double materiality disclosure requirements sit.
The EU requires corporations to report not only climate-related risk but also certain aspects regarding human and social issues, especially human rights
Disclosure and Collective Action Problems
These various initiatives raise many questions. First, can multiple forms of disclosure requirements co-exist? Second, is disclosure on its own sufficient? Third, is regulation of detriments viable and desirable?
Whilst it is possible to make many observations and comments on these questions, this is most constructively done within the context of a framework. The one that will be adopted here is to pose the question, what are these initiatives really seeking to do?
It was suggested previously that the starting point for them was the increasing detriments imposed by companies on the environment and society. On that basis, we are seeking to remedy and rectify the detriments that companies impose on others.
Is disclosure adequate on its own to achieve that? Arguably yes, in relation to shareholders if they or their agents they employ, their investment management firms, can appropriately interpret the information that is provided and act on it in making portfolio investment and engagement decisions.
For other parties to able to seek remedies for detriments, they clearly require the information of double materiality as proposed by the EU. Enforcement would then depend on the ability of affected parties individually or collectively to seek recourse through private law in the courts.
If it is felt that this remedy is deficient for information or collective action problem reasons, then either regulation or enforcement by public institutions through public as well as private law will be required. This would justify the approach of regulation proposed by the EU in the CSDDD.
Can disclosure with and without regulation to avoid harm co-exist? The answer is yes, and it already does in relation to other forms of disclosure and regulation, but not without its costs for international trade and capital market flows.
International variations in disclosure and regulatory requirements impose costs on the multinational operation of firms and institutional investors. The “Brussels effect”, by which what the EU does in terms of stringent disclosure and regulation impacting on the global operation of firms, will prevail, and firms outside the EU may feel it necessary for cost reasons to adopt EU standards in all their global markets.
However, there is another and more substantial question as to whether the EU approach is either desirable or appropriate. The EU approach is a coherent and consistent system of non-financial disclosures, institutional investor categorizations, and no-harm obligations. The approach of the EU in addressing avoidance of detriment is intrinsic to its impact on those affected by the activities of a firm as well as its shareholders.
However, it is not intrinsic to the firm itself. It relies on the imposition of external regulation on firms that retain a duty under corporate law to promote the success of the company for the benefit of their shareholders. Even under corporate laws that do not make specific reference to the benefit of shareholders and refer instead to the interests of the company, then pressures from capital markets in the form of hedge fund activism, hostile takeovers, and shareholder propositions require companies to prioritize the interests of their shareholders.
There are three consequences of this. The first is disclosure and regulation are regarded as just a cost to the business which should be minimized by strict adherence to the letter rather than the spirit of regulation and, if possible, avoided through ambiguity in its interpretation. In that regard, a “do no harm” regulation is either ineffective or places EU firms at a competitive disadvantage in relation to their non-EU peers.
Second, general all-encompassing definitions of harm create uncertainty and risk aversion on the part of firms in mitigating the threat of unanticipated violations of law. The Directive will therefore exacerbate existing concerns about a malaise in the dynamism, innovation, and investment of European firms in relation to their US counterparts.
Third, on the other hand, a precisely defined set of specific harms will encourage exploitation of loopholes in legislation and concentration on activities that are not constrained by regulation.
Furthermore, all forms of regulation suffer from asymmetry in information between firms and regulators about the consequences of corporate activities and where harms in relation to new technologies are likely to be present. In other words, the imposition of regulation on a misaligned underlying set of objectives of firms might be ineffective, inefficient, uncompetitive, or detrimental and have significant unintended or unexpected consequences.
International variations in disclosure and regulatory requirements impose costs on the multinational operation of firms and institutional investors
The Problem is the Nature of Corporations
The intentions of the EU may be worthy, but the approach may be misguided. However, US reliance on shareholder self-interest to address the problem is clearly inadequate. So, what is to be done? We should combine the EU desire to solve the problem with the US recognition that anything which is inconsistent with shareholder interests is unrealistic. We should ensure that there is an alignment between shareholder interests and the world in which we live.
Obvious though this might sound, it is not the way in which the corporation was conceived or exists today. As I describe in my most recent book, Capitalism and Crises: How to Fix Them, Oxford: Oxford University Press, 2024, the corporation emerged out of freedom of incorporation in the 19th century as a private entity determined by private corporate law.
Freedom of incorporation freed the corporation from the constraints of public charters and licences that prevailed previously. It released a tsunami of innovation and enterprise that powered the remarkable economic growth and prosperity of the 20th century. But it also drove the creation of the problems that have emerged in the 21st century relating to the environment and society, which are the motivation for the current wave of regulation and standards.
Instead of resorting to the knee-jerk reaction of reaching for regulation, we need a more imaginative approach that recognizes the fundamental source of the problem, not just its symptoms.
The problem lies in the nature of the corporation not just in the imposition of external regulation to constrain it. We should recognize that the presumption of the original design of the corporation that it is simply a private institution operating in the interests of its shareholders is misconceived. It is not, and it never was, though it is only recently that the consequences of this have become self-evident.
A business is a part of the system in which it operates – a system that comprises those on whom it depends and impacts as well as those whom it employs and rewards. It owes a fiduciary duty of loyalty to those who own and finance it, but that loyalty is in the context of its responsibility to the other parties on which it depends and impacts. Self-interest might encourage it to take account of the interests of those on whom it depends but does not necessarily require it to incorporate the interests of those on whom it impacts, at least in the short-term.
That failure is reflected in the problems we currently confront. A reliance on the long-term to resolve the problem, as some suggest, is not adequate to resolve problems that are very immediate and exacerbated by the short-term interests of their owners.
Furthermore, while time may heal and reveal, it may equally deceive and conceal. For example, a promise to reach net zero by 2050 may simply promote backloading of a resolution to achieve it and lacks both credibility and enforcement.
Instead, we need the ownership, governance, measurement, and performance of firms to be consistent with them profiting from avoiding not creating harm for others. It is the ability of firms to profit from harm that creates the fundamental misalignment between their interests and the rest of society and the natural world. Addressing this and ensuring that companies have the systems, processes, and measurement in place to adhere to it provides a credible and effective resolution of the problem. It allows the EU to achieve its objectives without threatening the viability and competitiveness of European companies, and it allows the US to retain its emphasis on the functioning of markets to promote social wellbeing.
Far from undermining or diminishing the significance of competitive markets, this proposal enhances the functioning of markets by ensuring a level playing field in which, as a matter of form, firms do not profit at the expense of others. It does not negate the need for regulation to prevent rather than just discourage particularly serious harms to humanity and the natural world, but it does so in the context of where there is an alignment, not conflict, of interest between regulator and firm, and a presumption that firms are required to avoid detriments even where they are not specifically regulated to do so.
We should recognize that the presumption of the original design of the corporation that it is simply a private institution operating in the interests of its shareholders is misconceived
Not Profiting from Harm
Is the notion of not profiting from harm too vague for incorporation in company law? Does it violate principles of legal certainty? Does it require directors and companies to make subjective judgments about the interests of different parties, for example, employees and customers? Why are private law in the form of torts and contracts and public law not adequate to adjudicate over whether and where harms occur?
The answer is that this is not a matter of private or public law under common law. It is not a tort but unjust enrichment under the law of equity. There may be no intended detriment or negligence on the part of the company, but harm is nevertheless experienced by the victims of environmental pollution, global warming, or social fragmentation resulting from the firm’s activities. It does not involve the payment of compensation to victims but restitution and disgorgement of unjust profits. It does not therefore require determination of the value of harms experienced by victims but of profits unjustly earned and the true costs that companies need to incur to avoid inflicting harms.
It is no different from the engineering cost estimates that companies routinely perform in the normal process of production. And if the company is required to ascertain the balance of interests of different parties (e.g., employees versus customers) then it should not profit (in the sense of earning an abnormal return) from the decision taken.
Legal certainty is therefore enhanced by the focus of the determination being not on subjective evaluations of harm inflicted but objective assessments of corporate underspending or inadequate cost provisioning, and it is therefore the application of traditional cost accounting.
The Brussels Effect and the Purpose of Business
What is therefore being proposed is that we recognize that the purpose of business is to profit from solving not causing problems for others and that this is reflected in corporate law. It does not require the simultaneous international adoption of such a law.
If for example, the EU made it a feature of European company law then it would apply to all companies operating in the EU irrespective of their country of domicile. The Brussels effect would therefore operate in promoting desirable legislative change elsewhere as against undesirable regulatory retaliation that the CSDDD threatens to provoke.
In sum, we should think carefully about what we are really trying to achieve by current regulatory and standardization initiatives.
We should ensure that they are effective in achieving their desired objectives at minimum cost and distortion to existing activities. What is currently proposed suffers from the risk of being either ineffective or undesirable or both. Instead, we should recognize the underlying cause of the problem and seek to remedy it rather than its symptoms through placing “not profiting from harm” at the heart of the purpose of the corporation and corporate law.
But there is a more substantial reason why it is to corporate law and purpose rather than just regulation that we should turn for solutions. It is not only through stopping firms from causing harm that we will address climate and social crises but also by incentivizing them to create benefits.
It is the power of profit to promote the initiative, innovation and investment required to solve existing problems and create new opportunities that will ultimately be our salvation. It is therefore to aligning profit and financial value with problem-solving not creation that we should turn to ensure competitive markets deliver what we want, not what we don’t want, without having to rely on regulation to ensure that.
Ferdinando Bocconi founded Bocconi University in memory of his son, Luigi, who died in the Battle of Adwa in the First Italo-Ethiopian War in 1896. Its mission is “to promote harmony between school and life”. As the first Italian higher education institution to grant a degree in economics, perhaps it might contribute to that mission by promoting harmony between business and life that recognizes the power of just profit to create a better life.
Colin Mayer discussed the content of this commentary in a recent IEP@BU event
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.