A Critique of the Sustainable Corporate Governance Report from the European Commission

In July 2020, the European Commission published the “Study on directors’ duties and sustainable corporate governance” by EY. The report purports to find evidence of debilitating short-termism in EU corporate governance and recommends many changes to support sustainable corporate governance. In a recent paper, we point out deep flaws in the report’s evidence and analysis.

Here’s a brief summary of those flaws. First, the report defines the corporate governance problem as pernicious short-termism that damages the environment, the climate, and stakeholders. But the report mistakenly conflates time-horizon problems with externalities and distributional concerns. Cures for one are not cures for the others, and a cure for one may well exacerbate the others. Second, the report’s main ostensible evidence for an increase in corporate short-termism is rising gross payouts to shareholders (dividends and stock repurchases). However, the more relevant payout measure to assess corporations’ ability to fund long-term investment is net payouts (gross payouts minus equity issuances), which is much lower and has left plenty of funds available for long-term and short-term investment. Third, when the report turns to other evidence for short-termism, it selectively picks academic studies that support its views on short-termism, while failing to engage substantial contrary literature. Significant studies fail to detect short-termism from truncated time horizons, and some substantial studies show excessive long-termism. Conceptually, some short-termism is an unfortunate but an inevitable side effect of effective corporate governance and may not be a first-order problem warranting wholesale reform. Finally, the report touts cures whose effectiveness has little evidentiary support, and, for some, there is real evidence that the cures could be counterproductive and costly.

Definition of the Problem: Short-Termism vs. Externalities and Distributional Concerns

The report starts with the concern that companies “focus on short-term benefits of shareholders rather than on the long-term interests of the company,” where the “interests of the company” encompass not just “the interest of shareholders [but also] . . . interests of employees; interest of customers; interest of local and global environment; interest of society at large” (pp. vi, viii). This definition of the problem conflates two or even three separate issues: short-termism on the one side and negative externalities and distributional concerns on the other.  Short-termism is the myopic, inefficient focus on short-term gains at the expense of larger losses in the longer term. Negative externalities are costs borne by people other than those who make the decision, which may create incentives to take actions that are harmful overall but that benefit the decision-maker. Distributional concerns arise even in the absence of externalities when some gain much more than others or value is distributed from groups that should be favored to groups that should be disfavored.

The report’s confusion of time horizons with externalities is illustrated in the following examples. The report’s main indicator for nefarious corporate short-termism is a high payout rate. Yet the report finds that the industry with the second-highest payout rate is oil & gas (p. 20). By the report’s payout logic, policymakers should push the oil & gas industry to pay out less and invest more in finding, refining, and burning hydrocarbons. But do policymakers really want to induce the oil & gas industry to drill more, refine more, and burn more hydrocarbons? We don’t think so.

As another example, the report lists corporate tax avoidance among the consequences of short-termism (p. 29). We agree that tax avoidance is a serious problem, but it has little to do with short-termism. In fact, corporations incur significant up-front costs to reduce their tax bill in the long term. This is an area where it would be better for the world (or at least for public budgets) if corporations were more myopic.

Inapposite Evidence: The Report’s Meaningless Gross Payout and Investment Measures

Section 3.1.1 of the report presents its main “[e]conomic evidence of short-termism in EU listed companies:” an increase in the gross payout (dividends and share buybacks) rate and a decrease in investment (CAPEX and R&D) intensity at European listed companies over the years 1992–2018.

This sort of reasoning will sound familiar to U.S. readers, who may have heard complaints about high corporate payouts sapping U.S. corporations of the ability to invest. But, first, gross payouts are misleading measures of whether companies retain the ability to invest in long-term projects, as companies are also raising new capital. It’s the net number that counts.  Moreover, the report’s focus on changes in gross payouts only compounds the issue because changes are meaningless without a baseline – perhaps payouts were too low before. Or perhaps gross payouts increased while new equity issuances increased as well. Similarly, the report’s restriction to listed firms is too narrow for policy analysis because what matters is what happens at all companies combined, including smaller companies that were not studied.

But let’s focus on the gross payout measure and its three glaring measurement and conceptual problems. First, the gross payout measure that the report emphasizes is not the right measure of whether companies are being deprived of the funds necessary for investment. Gross shareholder payout fails to account for, and is offset by, equity issuances that move capital from shareholders to companies. Net shareholder payout is the more relevant measure. Companies are not being deprived to the extent pay-outs are offset by pay-ins from new financing, be it debt or equity. This is largely what has been going on: Net shareholder payout rates are not particularly high. For example, during 1992–2019, EU companies distributed €2.6 trillion in dividends and €664 billion via stock buybacks (a total of about €3.2 trillion in shareholder payouts), about 60 percent of these companies’ total net income. But during the same period, EU listed companies issued € 2.5 trillion of equity. Net shareholder payouts were only €757 billion, or only 14 percent of these companies’ total net income.

Second, in its analysis of investment, the report concludes that there is a decrease in CAPEX and R&D intensity in EU listed companies because it examines incomplete, inconsistent, and skewed samples. For example, the report excludes from its examination of R&D intensity companies with negative net income, even though R&D in such companies is the best sign of a well-functioning capital market and there is no reason to exclude these firms. An examination of a complete and consistent sample reveals that CAPEX and R&D actually increased at EU listed companies over the time period considered in the report, both in absolute terms and as a share of revenue.

Third, the report’s preferred statistic of (gross) payouts as a percentage of net income (figures 1–5) is doubly misleading as a measure of whether payouts to shareholders deprive a company of funds required for investment. It wrongly implies that “net income” reflects the totality of a company’s resources that are generated from its business operations and are available for investment. In fact, net income is calculated after subtracting the many costs associated with future-oriented activities that can be expensed (such as much R&D expenditure). That is, net income is what is left over after certain investments. Indeed, a company that spends more on research will, everything else being equal, have a lower net income and a higher shareholder-payout ratio.

Overall, the volume of shareholder payouts by EU listed companies does not strip them of the ability to invest or innovate. Though EU listed companies have been investing heavily and increasingly, they have accumulated cash reserves that could be used for additional investments if they had attractive investment opportunities.

Biased Use of Literature

In the preceding section of our paper, we point to literature and data debunking the report’s major purported measure of corporate short-termism, gross payouts. Moreover, we added to that literature with an examination of the European data that, in our view, the authors of the report should themselves have done.

This is part of a larger problem of biased use of academic literature in the report. This bias manifests on two levels.

First, articles, including several high-quality, well-followed articles whose results conflict with the report’s conclusion are simply not cited or discussed. For example, several studies in top finance journals find that shareholder activism – a key driver of short-termism according to the report (p. 33) –  increases productivity, innovation, and key investment at targeted companies. We briefly cite and discuss several of the most prominent. The reader – and EU policymakers – should know of these studies,and should know why the report rejects them. Moreover, by not mentioning them, the report per force does not assess their strength and how they might temper its conclusions.

Second, a narrow focus on the literature examining the existence, or not, of short-termism is not a full survey of the literature relevant to short-termism. In the economic and finance literature, short-termism is seen as but one problem among many that governance needs to address. Reducing short-termism can readily raise other corporate governance costs. Judging governance arrangements solely by the existence of short-termism is like negatively judging a pharmaceutical that cures a deadly cancer solely by the existence of an uncomfortable side effect.

Ill-Considered Reform Proposals

The report considers policy proposals along seven dimensions: (1) broadening directors’ duties to include the interests of stakeholders, (2) relieving investor pressure by, e.g., increasing long-term shareholders’ voting rights, (3) requiring sustainability planning and disclosure, (4) tying executive compensation to sustainability metrics, (5) asking corporations to consider sustainability in board nominations, (6) “requiring corporate boards to establish mechanisms for engaging with and involving internal and external stakeholders in identifying, preventing and mitigating sustainability risks and impacts as part of their business strategy,” and (7) “[a]llow[ing] stakeholders (other than shareholders) to bring suits in courts for alleged violations by directors of the duty of care and loyalty.”

These proposals are questionable because their ostensible target – short-termism as inducing declining investment – may be modest or even a mirage (supra sections 2 and 3), whereas the real problems – externalities and distribution – are not clearly articulated in the report (supra section 1). We also discuss specific concerns with individual proposals. We hope that the European Commission will not follow through on the report’s proposals or if it does, proceeds only after thorough re-examination of the underlying problems and the suitability of the proposed solutions.

This post comes to us from professors Mark Roe, Holger Spamann, and Jesse Fried at Harvard Law School and Charles Wang at Harvard Business School. It is based on their recent article, “The European Commission’s Sustainable Corporate Governance Report: A Critique,” available here.