Shareholders and Business Ethics Chapter 6 PDF

Chapter 6 Shareholders and Business Ethics Andrew Crane, Dirk Matten, Sarah Glozer, Laura Spence Seiten: 233-282 In: Crane, Andrew et al. Business Ethics : Managing Corporate Citizenship and Sustainability in the Age of Globalization. Fifth edition. Oxford: Oxford University Press, 2019. Print. Bemerkung: Der Versand von Kopien und deren Weiternutzung unterliegt den Bestimmungen des schweizerischen Urheberrechts bzw. lizenzvertraglichen Bestimmungen (vgl. Homepage des Anbieters) und ist in der Regel für den persönlichen, schulischen oder betriebsinternen Eigengebrauch der Benutzenden erlaubt. Eine Publikation der Kopie, das Onlinestellen und die kommerzielle Weiterverwendung ist nicht gestattet. Die Einhaltung des Urheberrechts bzw. der vertraglichen Bestimmungen ist Sache der Benutzenden. [email protected] www.fhnw.ch/de/die-fhnw/bibliotheken Shareholders and Business Ethics 1iffii,i· M111 1Nt¥G@,fl,Ml Hl1,M iu 111¥i1til·----------- 1 1 Desc ribe the nature of shareholder relations to the corporation. Explai n the rights and the duties of shareholders in the context of corporate governance. Explain differences in corporate governance models and codes in various parts of the world. Identify t he ethical problems arising from the company-shareholder relationship. Evaluate the ethical implications of globalization for company-shareholder relations. Critically evaluate the roles of shareholder democracy, shareholder activism, and responsi- ble investment in promoting ethical business behaviour. Critically evaluate the role of sustainability indices and alternative forms of ownership in influencing corporations tow ards sustainability. Corporate governance Executive accountability Board diversity Insider trading Cryptocu rrency Shareholder activism Socially responsible investme nt 234 PART B Contextualizing Business Ethics INTRODUCTION: REASSESSING THE IMPORTANCE OF SHAREHOLDERS AS STAKEHOLDERS As we saw in Chapter 2, there are strong voices out there (for instance, Milton Friedman 1970) argu- ing that corporations exist, and indeed act, solely for the benefit of shareholders. The pursujt of divi - dends and increases in share prices to satisfy financial markets are major features of the dom inant capitalist model of value creation-but have also been widely cited as crucial contributory factors influencing firms to play fast and loose with business ethics. Indeed, as Stout (2016) argues, the corporate focus on only maximizing shareholder value is unnecessary, unworkable, and destructive! Even if we adhere to dominant views of shareholder dominance, nothing has brough t ethi - cal issues more attention than the financial crisis that began in 2007. For instance, between October 2007 and October 2008, shareholders investing in companies traded on the New York Stock Exchange lost on average 40□/o of their investments (Nanto 2008). As many of the reasons for this crisis have a strong ethical dimension (such as lending practices in the US mo rtgage industry), business ethics is now a core consideration for some investors, shareholders, and employees-as-shareholders. Other people point to the expansion of socially responsible invest- ment and the emergence of various indices of 'sustainable' stocks to suggest that sharehol ders are interested in societal good as well as their own self-interest. Whichever way you look at it. the role of shareholders is fundamental to understanding business ethics, and as such they are the first stakeholder group that we will focus on in this second part of the book. We first discussed the role of shareholders in the corporation (albeit quite briefly) in Chapte r 2 when we introduced the idea that while shareholders have a crucial stake in the corporation. this has to be understood within the context of other stakeholders, such as employees, con- sumers, and suppliers. In this chapter, we will investigate the finer nuances of this perspective. While maintaining support for a broad stakeholder perspective, we will examine the contention that shareholders, in some way, have a unique and superior claim upon the corporation. This relationship, as we shall see, confers certain crucial rights on shareholders, as well as imp osi ng some quite important responsibilities in terms of the governance and control of corporations. By examining this relationship in some detail, we will provide the all-important con text for discussing the various ethical issues that arise in shareholder relations, including insider trad- ing, executive pay, and money laundering. As we shall explain, both the impetus and the resolution of these issues and problems are shaped by certain national and contextual characteristics of corporate governance. We shall, therefore, go on to look at how shareholder relations vary quite significantly in diffe rent regional contexts. This will allow for a deeper understanding of the relationship between glo - balization and shareholder rights and responsibilities. Such issues have received a gro wing amount of attentjon due to the rapid global spread of the financial crisis in the late 2000s. We shall therefore move on to discuss the broader issues surrounding shareholder and stakeholder accountability before finally taking a look at how shareholders can use their unique position to address the question of sustainability of corporations. SHAREHOLDERS AS STAKEHOLDERS: UNDERSTANDING CORPORATE GOVERNANCE At the beginning of modern capitalism, and throughout the 19th-century Industrial Revo - lution, the common pattern of governing companies was a very simple one. At tha t time. industrialists, such as the Cadburys in the UK and the Thyssens in Germany, both owned and CHAPTER 6 Shareholders and Business Ethics 235 managed their companies directly. Today, except in very small businesses, owner-managers are considerably rarer. Some exceptions to this include David and Charles Koch in the US and Richard Branson and his Virgin conglomerate in the UK. However, the common pattern in large corporations is a separation of ownership and management functions. In fact, this separation is at the heart of modern capitalism: owners no longer have a personal relationship to 'their' co rporation, but rather they buy a 'share' in the corporation and expect the managers and employees of the company to run it in their (and other shareholders') interests. The debate about the separation of ownership and control dates back at least to the 1930s and the landmark publication by Adolph Berle and Gardiner Means (1932). This debate essentially problem atizes the notion of ownership when applied to corporations. In our everyday life, to own a bike, or a car, or even a house implies that we are able to do with our property pretty much whatever we like, and therefore can exert a considerable amount of control over it. After all, as we discussed in Chapter 2, the right to property is one of the fundamental rights of citizens. If I wa nt to paint my bike green, ride it down the street, or even completely destroy it, then I can. However, with regard to the ownership of corporations there are some crucial differences (see Pa rkinson 1993: 56-63; Monks and Minow 2011): Locus of control. The control of the owned property no longer lies in the hands of the owner. The actual control lies in the hands of the directors, the board, or another commit- tee. Shareholders thus have, at best, indirect and impersonal control over their 'property'. Fragmented ownership. There are so many shareholders of a corporation that one in- di vidual could hardly consider themselves to be the owner in the same way that the plumber next door owns their own company. Divided functions and interests. Shareholders have interests that are not necessarily the same as the interests of those who control the company. Shareholders might seek profits, while managers seek growth. Furthermore, a shareholder has no real task and responsibil- ity regarding their property apart from keeping a piece of paper that entitles them to a share in the company. Given this somewhat modified interface between shareholders and directors of corporations, we can analyse their relationship a bit more closely. Obviously, the primary consideration for sha reholders is the protection of their investment that, in the given context, amounts to certain specific 1ighls (Figure 6. 1). Most notably, these rights do not include the right to a certain amount of profit or dividend; this is not only subject to the effort and skill of the management but is also-even if the com- pany is profitable-dependent on the decision of the other shareholders in the general meeting. As Fox and Lorsch (2012) argue, shareholders contribute three resources to corporations: money (the provision of capital), information (in the guise of stock market trends and analysis), and discipline (keeping managers in check). Managers, on the other hand, are entrusted with the duty to run the company in the interest of shareholders. This general duty breaks down into vario us more specific duties (Parkinson 1993: 76-100): Duty to act for the benefit of the company. This obligation can be interpreted both in terms of short-term fmancial performance and long-term survival of the company. Principally, it is for the shareholders to decide at which level they want the company to perform; however, managers have a considerable amount of discretion in actually imple- menting this duty. 236 PART B Contextualizing Business Ethics Figure 6.1 Shareholder rights Source: Republished with permission of John Wiley and Sons, Inc. from Monks and Minow, Corporate Go1 er11 a11ce (2011) ; perm ission conveyed through Copyright Clearance Center, Inc Duty of care and skill. Living up to this duty implies that managers seek to achieve the most professional and effective way of running the company. Duty of diligence. This last duty is the most general one and, as a rather legally flavoured term, 'refers to the expected level of active engagement in company affairs' (Pa rkins on 1993 : 98). Consequently, this is the broadest way of establishing pressure on managers to invest every possible effort in running the company in the most successful way. Clearly, the duties of managers are rather broadly defmed. After all, one of the main tasks of a manager is to manage the 'property' of shareholders in their interests. This involves so many things that it is hard to pin it down to concrete activities and initiatives: which strategies, whi ch products, which international investment projects will add to the success of the corporation? These questions are already hard to tackle for an insider, let alone for a shareholder who has only a little knowledge about the internal workings of the corporation and the fmer specifics of its products, markets, and competitors. The relationship between shareholders and the company is therefore defined by relatively narrow, but well-defmed, rights for the shareholder and far-reaching, but rather ill-defm ed, duties for managers, or for the fnm in general. It is no wonder that this situation has always been a delicate one and that conflicts continue to plague the relationship between man ag- ers and shareholders. Such conflicts focus on the nature of corporate governance (Parki nson 1993: 157). Corporate governance includes various rules, processes, and structures that enable CHAPTER 6 Shareholde rs and Business Ethics 237 shareholders to exercise direction and control over managers. This includes how they can influ- ence goal definition, supervision, control, rewards, and sanctioning of management. In the na rrow sense, this just focuses on shareholders and the senior executives of a corporation, but in a broader sense, it also encompasses other stakeholders that might have a legitimate role in directing and controlling managers. I Corporate governance The rules. processes, and structures through which corporations are directed and controlled in the interests of shareholders and other stakeholders. COR PORATE GOVERNANCE: A PRINCIPAL-AGENT RELATIONSHIP At first glance, it might seem unlikely that corporate governance should bring up too many ethical issues. After all, shouldn't shareholders and senior executives want the same thing, namely a growing, profitable company? Let us look at some high-profile governance scandals to see just what some of the problems could be: Two weeks after taking over as CEO of Japanese electronics company Olympus in October 2011, Michael Woodford discovered that the company had hidden $1.5 billion of invest- ment losses and illegal payments in a so-called 'tobashi ' (concealment) scheme. When he exposed the problem he was immediately fired as part of a cover-up by longstanding board members. The scandal wiped out 750/o of the stock market valuation of the com- pany. 1 How was it possible that senior management could hide such an amount of losses from shareholders and persist in covering up their past mistakes? In 2014, General Motors (GM) faced a lawsuit from its shareholders, alleging securities fraud in the way that the company had handled a recall of 2.5 million cars due to a faulty ignition switch. The company had allegedly known about the problem for more than ten years, resulting in, by some estimates, up to 150 people being killed in accidents. How was it possible that GM could conceal the problem fo r such a long time from its 'owners', who suffered significant losses when the scandal fmally broke in 2014? In 2018, British facilities management and construction services company Carillion en- te red into compulsory liquidation amidst £1.5 billion of accrued debt. Employing over 43 ,000 employees globally, Carillion was responsible for some of the world's most iconic buildings, such as the UK's Tate Modern and the Yas Viceroy Abu Dhabi Hotel. It also held responsibility for large public sector projects, including the building of hospitals and the management of schools. The collapse of Carillion was seen to be a corporate govern- ance failing. Calls to encourage more transparency in corporate board decisions and to 'toughen ' up UK governance codes ensued. How had Carillion managed to continually win valuable government projects in the wake of profit warnings and debts? Think of the duties of managers to their shareholders from the perspective of ethics of duty (Kant's categorical imperative test). Apply this theoretical lens to the three incidents described above. Visit the onli ne resources for a suggested response. 238 PART B Contextualizing Business Ethics Figure 6.2 Agency relation between the manager and shareholder Seeks profits, rising share price, etc. Seeks remuneration, power, esteem etc. The essential problem here is th at firm-sharehold er relationships cannot be so easil y framed in a contract that neatly states rights a nd responsibilities. As auth ors li ke Jen sen and Meckling (1976) have shown, the relationship is a so-called agency relation. Thi s means that the shareholder is a principal who contracts management as an agent to act in th eir interest within the boundary of the firm. Figure 6.2 presents a very basic vi ew of the rela- tionship between manager and shareholder using this framework. Firms are much more than just bo ards, managers, shareholders, and debtholders, but situated within compl ex poli tical and regulatory environments. This harkens back to our discussion of stakeholder theory in Chapter 2. Shareholders want the managers in the firm to perform a certain task for them. As a prin ci- pal, they want managers to do certain things with their property. Managers as agents, on the other side, also have their own interests. Agency relations are special relationsh ips due to two features that are by no means necessarily common for all other manager-stakeholder re lations (Shankman 1999): 1. There is an inherent conflict of interest between shareholders and managers. Sh arehold- ers want profits and increases in share price, which require major effort on the part of managers, and may suggest low salaries (i. e. the more managers are paid, the lower the resulting profit for shareholders). Managers want to have high salari es and might pursue power and prestige to the detriment of shareholder value. Consider the fa ct that acquisi- tions and mergers in the most competitive frnancial markets such as the US, UK, and Canada typically provide no additional value to shareholders and in fact often erode shareholder value (Alexandridis, Petmezas, and Travlos 2010). 2. The principal has only limited knowledge and insight into the qualifications, actio ns, and goals of the agent, something economists refer to as an informational asy mm etry. Th e shareholders of Olympus and GM in our examples above might have been happy with the profitability of their companies, yet they only had limited insight into what managers were doing and the risks this created for them. lt is the combination of these two characteristics that makes shareholder relations with manag- ers, and the whole issue of corporate governance, so precarious. lndeed, conflicts of inte rest and informational asymmetry can be seen to underlie a host of ethical problems and dil emm as for either side to deal with in the area of corporate governance, as we shall see in a mom ent. Before we move on to the main ethical issues pertaining to shareholders, though, we need firs t to clarify the position of shareholders in relation to other stakeholders. Specif1cally, it is impor- tant to recognize that there are different models of corporate governance in different parts of the world. CHAPTER 6 Shareholders and Business Ethics 239 DI FFERENT FRAMEWORKS OF CORPORATE GOVERNANCE GLOBALLY In its broadest sense, corporate governance describes how the priorities of the corporation should be determined and, ultimately, who the company is there to serve. Different models of corporate governance operate in different countries, and so the ro le of shareholders varies quite significantly between different countries internationally (Aguilera and Jackson 2010). For many commentators there are two broad systems of corporate governance. On the one hand, there is the Anglo-American model of capitalism (Aguilera et al. 2006), which is primarily a market- based form of corporate governance. The Anglo-American model is predominantly evidenced in the UK and the US, as well as Australia, Canada, and Ireland. Crucially, the Anglo-American model has also started to influence many emerging economies, particularly in Latin America and Asia (Reed 2002). On the other hand, there is a continental European model, sometimes also called 'Rhenish Capitalism' or 'social capitalism', given its focus on extensive state regulation of market outcomes (Albert 1991). This model is a more network- or relationship-based form of corporate governance, of which the European model is the oldest and most widely known. The continental European model is evident throughout most of the rest of Europe, most notably France, Italy, Germany, Spain, and Scandanavia as the largest economies on the continent. However, a similar approach, based on relationships (rather than markets), can also be found in many countries, in particular in the developing world, and also in Asia (Claessens and Fan 2002), which some refer to as a relationship-based approach to corporate governance (Clarke 2007). Figure 6.3 provides an over- view of the key characteristics of the Anglo-American, continental European, and Asian models. Figure 6.3 Key characteristics of corporate governance in Anglo-American, continental Eu ropean, and Asian models ANGLO-AMERICAN CONTINENTAL EUROPEAN ASIAN MODEL MODEL MODEL Source of capital : Source of capital: Source of capital: Banks and loans (not just the Family-owned, bank-financed Stock market stock market) and state-owned Focus: Focus: Focus: Shareholder value, employee Shareholder value, emp loyee Shareholder value retention and non-profit goals retention, and non-profit goals Executi ve remuneration: Executive remuneration : Execut ive remun eration : Based on stock ma rket Less directly performance- Less directly performance- performance related related Ethical concern s: Ethical concerns: Et hical concerns: Insider trading, manipulated Interests of large shareholders Reporting, transparency, and accounting statements over individual investors accountability underdeveloped Agency: Agency: Agency: Employees typica lly have no Supervisory board appointed by Relationship-based approach say in the control of the firm emp loyees (stakeholder focus) invo lving actors in supp ly chain 240 PART B Co ntextu alizing Business Ethi cs We can also consider differences and similarities from the perspective of corporate govern- ance in different parts of the world. BRIC (Brazil, Russia, India, China) countries te nd, in one way or another, to follow what is akin to a relationship- based appro ach, according t o their specific economic and political heritage. In all of these countries, however, we see some degree of a shift towards more market-based mechanisms. An interesting exa mple of how these di ffer- ent trends blend into each other can be found in the Indian approach to corporate govern ance (S arkar and Sarkar 2000), which on the on e hand is similar to the contin ental European model (as it is based on large block holdings of majori ty investors), but on the other hand also demo n- strates elements cha racteristic of the Anglo-American approach (since many of these investors are actually companies and senior executives). This development is particularly encouraged by comparatively large numbers of foreign investors. Similar hybrid forms of governance can be found in many emerging economies, such as Brazil, where it is only in the last few decades that privatization has taken effect and companies have tried to attract more forei gn cap ital and therefore adopted elements of the Anglo-American model (Rabelo and Vasconcel os 2002). The Russian case, furthermore, is interesting in particular for the phenomenon of owner-manag- ers, often referred to as 'oligarchs', who amassed large parts of privatized form er state-owned industri es in the Boris Yeltsin era of the 1990s. With owners being managers at the same tim e, considerable conflicts of interest might obviously a rise. The Chinese and South Korean contexts offer even more complexity, as ownership is highly concentrated in state-own ed fa mily compa- nies, some private enterprises, and, in the South Korean context, in 'chaebols'-large, family- ru n industri al conglomerates. Although it is useful to simplify corporate governa nce frameworks along these li nes, it is important to take into account some important qualifications. First, as we have in dicated , there are considerabl e pressures towards convergence in governance models, leading to hybrid models and shifts in the form if not always the substance of traditional govern ance arrange- ments (Yoshikawa and Rasheed 2009). For example, many of the more rel ationshi p-oriented forms of governance appear to be gradually t aking on some elements of the Anglo-American model, but these are often resisted or combined with existing approaches, rather th an simply replacing them. Especially since the global financi al crisis of the late 2000s, the Anglo-American approach has been increasingly brought into question and it is now rarely considered (as it per- haps once was) the 'best model' of corporate governance (Aguilera and Jackson 2010). Second, there is a considerable level of heterogeneity, as different countries characterized as using the same system may actually differ quite considerably. This goes not only fo r th e diverse countries captured by the 'continental European' umbrella, but also, as Aguilera et al. (2006) show, for the ostensibly similar approaches evident in the UK and the US, which actually di ffer in a number of key respects. Focusing on a firm-level analysis, there may be a nu mb er of reasons as to why corporations do not conform to dominant governa nce logics. Third, looking at the concept of corporate governance deviance, Aguilera, Judge, and Terjes- en (2018) suggest that while the national governance context 'sets the stage' for defm ing nor- mative governance expectations outside of the firm , entrepreneurial motivations emanating from within the firm see firms improvise their performance through risk-taking, proactive, and innovative behaviour. Aguilera et al.'s (2018) theory helps to articulate why firms under- conform (adopt governance practices that fall short of the country's govern ance standards) or overconform (exceed prevailing governance norms) based on social and/or commerci al motives, particularly in different country contexts. CHAPTER 6 Shareholders and Business Ethics 241 Thinking of different corporate governance practices around the world in the context of moral relativism, are th ese just 'different' (i.e. reflecting different cultural and cu stomary practices) or w ould you argue that some of them are actually more or less ethical? Visit the online resources for a suggested response. ETHICAL ISSUES IN CORPORATE GOVERNANCE Corporate governance has been a business ethics topic high on the agenda of all major econo- mies in recent years. Partly this has been the result of various scandals that have hit the head- lines since the turn of the century. This started with the 'dot-corn bubble', and the financial sca ndals that saw the spectacular bankruptcy of companies such as Enron, Tyco, and World- Com in the US, and shocking revelations of financial irregularities at Parmalat in Italy and Ahold in the Netherlands, among others. Attention later turned to the collapse of many banks and financial institutions in the financial crisis of 2008 and its aftermath. A swathe of govern- ance scandals in Asia in the 2010s, including at Olympus, Tokyo Electric Power, and Daiwa Pa per in Japan, also led to suggestions of 'seemingly free-wheeling behavior-and disregard fo r corporate governance... among top management at some of Japan 's leading companies ' (Tabuchi 201 I). More recently, in 2016 and 2017 we have witnessed the calling out of corpo- rations who have offshored profits into tax havens,2 leading to calls for greater transparency into the financial activities of multinational corporations and how they are controlled. Such phenomena have resulted in unprecedented interest in the ethical dimensions of corporate governance. In the following sections, we will examine the main issues arising here, focusing specifically on those that primarily affect shareholders, namely: executive accountability and control, executive remuneration, ethical aspects of mergers and acquisitions, and diversity on corporate boards. EXECUTIVE ACCO UN TAB I LITY AND CONTROL Looking at corporate governance, there are certain core elements that need to be present in order for the principal-agent relationship to be managed effectively. The most important element is a separate body of people that supervises and controls management on behalf of principals-namely, a board of directors. It is the board to which the chief executive officer is accountable for their performance, and the board that will appoint the CEO and determine their salary. Unless the board has effective oversight and control of senior executives, the princi- pal-agent relationship collapses. Effective corporate governance therefore relies on executive accountability. I Executive accountability The systems and processes through w hich senior executives can be held re sponsible for the performance of the firm by shareholders and other stakeholders, typically via the board of directors. 242 PART B Contextualizing Business Ethics In practice, the drive for executive accountability and contro l tends to result in a du al struc- ture of the board of a publicly owned corporation. On the one hand, there are execu tive din~c- tors who are actually responsible for running the corporation as well as supposedly provid in g a link between managers and shareholders. On the other, there are non-executive directors wh o are supposed to ensure that the corporation is being run in the interests of principal s, usuall y shareholders. The alternative global governance frameworks have important differences in th e wa y th ar this board is structured and composed. There are basically two extremes. In the Anglo-America11 and Asian models, there is usually a single-tier board that comprises both executi ve and non-executive directors. In continen tal Europe, however, a two-tier board is more comm on. The upper tier is composed of non-executive directors and the lower tier of executi ve di rec tors. The upper tier, often also called a supervisory board, effectively oversees the lowe r rier, which is more concerned with the day-to-day running of the company and includes representatives of stakeholders other than just shareholders, including banks and employees. Perhaps un surp ris- ingly, therefore, there is considerable variability across countries in the extent to which execu- tives are actually held accountable for the performance of their firms, for exampl e by bein g fired for poor returns (Crossland and Chen 2013). Regardless of the structure of the board, the central ethical issue here is clearly the ind epend- ence of the supervisory, non-executive board members. They will only be able to reasonably acr in the principal 's interest if they have no directly conflicting interests. In order to achi eve rhi s. a number of points are important (see Nader 1984; Boyd 1996): Non-executive directors should be largely drawn from outside the corporation. They should not have a personal fmancial interest in the corporation other than the in- terests of shareholders. This includes the fact that the remuneration for the non-execuri ve director role must not significantly exceed a reasonable compensation for time and oth er expenses. They should be appointed for a limited period in order to prevent them from gettin g too close to the company. They should be competent to judge the business of the company. This would require, and to some degree allow, a limited number of insiders, such as former executives or even works council members (such as in certain parts of Europe). They should have sufficient resources to get information or commission research in to th e corporation. They should be appointed independently. This would be either by the sharehold ers di- rectly in the annual general meeting, or through appointment by the supervisory boa rd. A further element of supervision comes from an independent auditor who audits the work of rh e executive board-normally the main aspect of their role-and also of the non-executive bo ard. We will discuss the role of auditors and the ethical issues involved a little later. Despite the guidelines above, the independence of non-executive directors rem a in s a delicate issue. Often they belong to the same peer group as executive directors, or are them- selves in executive roles elsewhere, or have been in such roles in the past. This means th at a completely neutral and independent approach will always be qui re difficult to achi eve (Gordon 2002). CHAPTER 6 Shareholders and Business Ethics 243 EXECUTIVE REMUN ERATION The f111ancial crisis of the late 2000s brought the issue of executive pay to centre stage in an unprecedented fashion, as executives of bankrupt or fa il ing companies continued to earn mil- lions in salaries and billions in bonuses. 'Shameful' and 'the height of irresponsibility' were US President Obama 's comments on what continued to be common practice, not only in the US, but in many other countries across the globe. Public concern about excessive executive sa la- ries has fuelled a rise in online attention to the issue, including a slew of activist websites (e.g. UK-based High Pay Centre), responses in legislation (e.g. the ratio between CEO compensation and the median salary of employees published through the US Dodd-Frank Act requirements), and advisory consultants (e.g. Salary.corn in the US and Canada) that seek to promote transpar- ency about current pay levels. The general trend towards ever-increasing executive salaries has been driven by the domi- nance of the shareholder value ideology. However, the key element here actually derives from an attempt to address the core of the agency problem: in order to align the interests of both parties, the perfect solution appeared to be to pay executives in the same 'currency' that mat- te rs to shareholders, namely dividends and rises in share price. The logical conclusion then is to pay executives in shares-or more commonly, in options that allow executives to buy shares on a fu ture date. In order to make the incentives work, it wou ld not be sufficient to pay them with just a few shares or options but to a degree that substantially impacts on their wealth. As a co nsequence, the US in particular has led the way in rewarding senior managers with mas- sive stock option deals. This approach of performance-related pay has especially taken hold in the f111ance industry, resulting in high salaries and bonuses even for mid-level executives in financial services and banking. In 2016 the average CEO salary was $ 15. 6 million; almost 270 times more than the US average salary. Indeed, in the UK, 4 January is labelled as 'Fat Cat Wednesday' ; the day when a CEO has already earned more than an average worker earns in an enti re y ear. Meanwhile, the link between executive remuneration and stock market performance has always been somewhat tenuous (Walsh 2008). Exa mples such as these unveil many of the ethical problems with executive pay in f1rm - shareholder relations: First, there is the issue of designing appropriate pe,jormance-re/ated pay in a world of reinvigorated shareholder value (Koslowski 2000). In order to tackle the problem of diver- gent in terests, most executive remuneration packages now contain a significant number of share options to align shareholder and manager int erests, but this has resulted in rock- eting salary levels and uncertain effects on share prices. Secondly, these shifts in remuneration show the influence of globalization on executive pay. Since the market for executive talent is a globa l one, increases in one country tend to drive up pay internation ally. Thirdly, the influence of the board appears to be somewhat limited and often fails to re- flect shareholder (or other stakeholder) interests. Why would shareholders want to reward a CEO who had overseen a period of poor performance? Such problems show few, if any, signs of diminishing. In Europe, the EU Commission began attemp ts in the mid-2010s to strengthen shareholder rights with regard to executive compen- sation, whi le Switzerland even put the topic to an unsuccessful public referendum in 2013 244 PART B Contextualizing Business Ethics (Dijkhuizen 2014). In the US, reforms to CEO remuneration and increased transparency ove r CEO-staff salary ratios are being pushed by the Dodd-Frank Wall Street Reform of 2010 and the UK may look to make a similar legislative move. What drives reform here is, of course, not so much the public feeling sorry for shareholders, but the fact that the pay differentials between those at the top and those at the bottom appear to be so inequitable. We shall cover this issue again in Chapter 7 when we address the question of fair pay for employees. BOARD DIVERSITY A substantial body of literature has looked at the attributes of successful corporate boards and how these attributes translate to corporate performance (Payne, Benson, and Finegold 2009). Such research argues that companies should work towards board diversity : a broad range of skills, backgrounds, age, gender, ethnicity, and sexual orientation represented on the board of directors. Paying attention to such recommendations can reap dividends for contemp orary businesses, with research suggesting that increased female board representation can positive- ly influence a firm's financial performance and corporate governance practices due to th eir knowledge, experience, and values (Post and Byron 2015), leading to improved CSR ratings (Bear, Rahman, and Post 2010). However, in practice, the representation of women on bo ards remains low in the vast majority of corporate boardrooms. A recent UK study found th at just I 220/o of the companies surveyed had a woman on their board (Turner 2017).3 Ethnicity figures paint a similarly dismal picture. In 2017, Fortune reported that in the US, just 220/o of new bo ard director appointees were African-American, Hispanic or Latino, or Asian-American. 4 IBoard diversity A broad range of skills, backgrounds, age, gender, ethnicity, and sexua l ori enta tio n represented on the board of directors. While there have been important legislative forays into making boardrooms more diverse in Norway and Spain, most countries prefer to mandate boardroom diversity on a more voluntary basis. This affords firms with the freedom to appoint boards that are in fitting with their own values and aspirations, leading to questions about the fairness of recruitment and selection processes. We will return to this theme in Chapter 7 when we discuss workplace discriminati on. Yet the future is not all gloomy. As Dhir (2015) illustrates, Norway's introduction of a quo ta- based approach to achieving gender balance in corporate boardrooms has spurred substan tive corporate governance reform. With women holding over a third of seats on Norwegian stock index companies, such initiatives, which were deemed by many to be controversial, are openin g up dialogues around effective methods of corporate governance in the global marketplace. The extent to which these developments create positive implications for other areas of diversity is yet to be seen. ETHICAL ASPECTS OF MERGERS AND ACQUISITIONS From a societal point of view, mergers and acquisitions might be encouraged if they involve the transfer of assets to an owner who will use them more productively and thereby create more wealth. The alternative is to leave the assets in the hands of a less-effective management, with higher costs, less innovation, and other costs to society. However, there are a number of CHAPTER 6 Shareho ld ers and Business Ethics 245 ethical issues that might arise, as many examples of unsuccessful mergers demonstrate. The central source of ethical concern in this context is that managers may pursue interests that are not co ngruent with the shareholders' interests. A study by KPMG of 700 mergers found that only 170/o created real value for shareholders, while more than half actually destroyed value (Surowiecki 2008). As a result of such failures, some companies have reversed their decisions and have begun demerging. Consider Hewlett-Packard, which after having spent more than $60 billion in the previous decade on acquisitions, announced in 2014 that it would be split- ting its business. More recently, L'Oreal sold UK beauty brand The Body Shop to Brazilian cosmetics company Natura in 2017 in the wake of increasing competition in the market for ethical beauty and cosmetics. The Body Shop takeover shocked many at the time because of the seeming incompatibility between the company's ethical focus and L'Oreal 's more main- strea m credentials, and recent challenges may suggest that these early critics may prove to have been correct. Basically, the conflict boils down to a desire for power and prestige among senio r executives in driving mergers on the one hand, and the interests of shareholders in driving profit and share price on the other. There is, in particular, a wealth of discussion in the American business ethics literature on this issue, mainly since the US business system strongly encourages these types of transac- tio ns-more so than is the case in tightly regulated Europe, or in BRIC countries with more na rrowly held stock ownership. However, with an increasing deterritorialization of fmancial markets, these practices have also become more common across the globe in recent years, as the example of mergers of French, German, or Swedish companies in the telecommunication and utility industries illustrates. In the following, we will look at the main issues that have arisen or are likely to arise. Next to 'normal' mergers, there are particular ethical problems involved in so-called hostile takeovers. Here, an investor (or a group of investors) intends to purchase a majority stake in a corporation (often secretly) against the wishes of its board. Without going into a detailed philoso phical debate, there are basically two lines of argument here. On the one side, it could be argued that hostile takeovers are ultimately possible only because shareholders want to sell their stock; otherwise they would keep it. On the other side, an ethical concern may arise with the remai ning shareholders that do not want to sell. If the company is taken over by someone who has different ideas about the corporation-for instance, an 'asset stripper' that wants to split the company and sell off certain parts-a hostile takeover might interfere quite signifi- cantly with the property rights of those remaining shareholders. Even relatively friendly acquisitions can create ethical challenges when they are predi- cated on realizing shareholder value at the expense of other stakeholders. For instance, Jack Welch, the well-known former CEO of General Electric (GE), acquired his nickname 'Neutron Jack' because he turned GE into one of the best-performing conglomerates on Wall Street through the acquisition of all sorts of corporations, and significantly restructuring an d downsizing them immediately after takeover. The buildings and assets remained; only the peopl e had to leave-similar to the effect of a neutron bomb. Very often, acquisitions only ta rget the profitable parts of the bought-up corporation , while at the same time the other parts will be liquidated. Sometimes these acquisitions even focus only on the brand value or certain patents and technologies of the bought-up firm, with the consequence that other stakeholder interests, such as those of employees or local communities, are seri- ously disregarded. 246 PART B Contextualizi ng Business Ethics THE ROLE OF FINANCIAL MARKETS AND INSIDER TRADING There has been a remarkable silence in the literature on fmancial markets with regard to ethical issues (Rudolph 1999). A simple justification for this would be that, as long as the rul es of the market are set fairly and everyone plays according to these rules, no ethical dilemm a is to be expected. Yet behind this argument is the assumption of a perfect market, and in particul a r the assumption that, ultimately, all publicly available information about the company is refl ected by the stock price. However, we all know that this simple rationale of 'the stock market never lies' is only part of the truth. Sometimes, the alleged 'information efficiency' of stock markets is quite flawed, as the following issues show. Speculative 'faith stocks' An often-discussed problem is the speculative nature of share prices. This not only becam e evident in the frnancial crisis of the late 2000s, but also during one of its predecessors, the burst of the 'dot-corn' bubble in the late 1990s. Start-ups that had not made a single cent in pro fn but were valued at billions of dollars on the Nasdaq in New York or the Neuer Markt in Frank- furt then took this speculative element to an extreme. These stocks were not so much built on solidly calculated profit expectations, but were more like 'faith stocks' (Gordon 2002), bui lt on little more than blind faith. Even a company such as Amazon.com, which is one of th e success- ful survivors of that crisis, needed more than seven years to make even a dollar in profit. Even now, after twenty years in business, it still does not consistently generate profits and regul arl y reports quarterly losses. Yet its share price rose from $34 to $ 1485 from 2007 to 2018, provid in g significant returns to its investors. In some sense, the fmancial crisis of the late 2000s had similar roots. The complex structured finance products that mortgage lenders and other fmancial institutions traded to manage th e risk of sub -prime mortgages were all based on 'faith' that the real estate market would continu e to rise. As long as this faith held, most actors involved thrived. When the downturn set in , how- ever, it not only turned out that the optimism was misplaced, but also that the products were way too complex for the managers involved to foresee the likely consequences. This is an issue we will return to in Ethics on Screen 6. One problem here is that many pensioners, whose funds had invested in these bonds, lost large parts of their income. The ethical issue clearly lies in the fact that, while stock pri ces always contain an element of speculation, stock markets do not always fully reveal th e amo unt of uncertainty. This might be somewhat trivial for brokers or other stock-market professional s : however, with large institutional investors investing other people's money in these sto cks, th e fact that these bonds may be based entirely on speculation can be said to be close to an abuse of trust. This also questions the role of analysts and accountants (see section 'The rol e of fm an - cial professionals and market intermediaries') who, among others, are responsible for ensuri ng informed transactions on the stock market. High-frequency trading With the rise of electronic trading and an ever-increasing speed of data processing, a new area of ethical concern has arisen around what is often referred to as 'high-frequency tradin g' (HFT) (Lewis 2014). Brokers using HFT buy financial assets and only hold them for microseco nds , to benefit from minimal changes in the value of the assets, before selling them. There are tw o CHAPTER 6 Shareholders and Business Ethics 247 main problems with this practice (Davis, Kumiega, and Van Vliet 2013). First, depending on the hardware of the company and its cable connection to the electronic stock exchanges, some players in the market have their information microseconds before competitors and thus might be said to have an unfair advantage. The other problem is that all of those trades are executed thro ugh electronic algorithms, and since most actors in the market use very similar algorithms, the risk of market crashes is quite substantial. So, for instance, a short but dramatic 'flash crash' of the Dow Jones Index by more than 1,000 points within a few minutes in May 2010 is blamed on such an effect of HFT. It is exacerbated by the fact that HFT only generates substantial benefits when the size of the investment is very high. HFT is currently under scrutiny by many regulato rs. Sh ort selling Short sell ing, or 'shorting', is the process whereby an investor borrows a security (a fman- cial instrument that holds monetary value) and immediately sells it in the hope of purchas- ing the security back at a later date at a lower cost. The process is not only risky, but also raises important questions around how ethical it is to profit from the decline of a company; a top ical question, given tha t hedge funds are expected to make around £200 million in sho rt-selling shares in Carillion, the UK outsourcing company that went into liquidation in 2018 (discussed earlier). While such approaches do little to further a longer-term outlook in the fmancial services sector, some argue that short sellers are not callous individuals who put profit before ethics, but are in fact bastions of the fmanci al markets in ensuring stock liquid ity and honest prices for stocks. As we will see now in this chapter's Ethics on Screen 6-The Big Short-through astute analysis, financial professionals pl ayed a pivotal role in pre- dicti ng the collapse of the US housing market, with monumental consequences. As a result, the practice of short selling remains highly regulated by the International Organization of Securi ties Commissions (IOSC0). 5 In sider trading Insider trading occurs when securities are bought or sold on the basis of material non-public info rmation (Moore 1990). Although it therefore shares with HFT a problem of some traders benefiting from an unfair advantage, it is a much longer-standing problem that has been a fea tu re of stock markets for more than a century. The point is that executives of a corporation and other insiders know the company well, and so might easily know about events that are likely to have a significant impact on the company's share price well in advance of other poten- tial traders. Consequently, insiders are privileged over other players in the market in terms of knowledge, a privilege that they could take advantage of to reap a questionable profit. I Insider trading A finan cial market transaction based on information that is not publicly available to all other market part ici pants. In the long run, insider trading can undermine investors' trust in the market (Carroll and BuchJ10ltz 2012: 105)-a problem that has led many stock markets to forbid the practice. How- ever, concerns around insider trading persist, and certainly the US courts have pursued insider trading cases with great vigour in recent years. For instance, the high-profile case of hedge fund owner Raj Rajaratnam and former managing director ofMcKinsey, Rajat Gupta, led to both men 248 PART B Contextua lizing Business Ethics ETHICS ON SCREEN 6 The Big Short · D The Big Short will affirm your deepest cynicism about Wall Street while simultaneously restoring your faith in Hollywood. A.O. Scott, The New York Times 'A few outsiders saw what no one else could : The whole world economy might collapse.' A killer line from 2015 Hollywood blockbuster The Big Short delivered by Jared Ven nett (Ryan Gosling); a Deutsche Bank trader who was one of the first to bet against the US subprime-mortgages market. The line not only captures the scale of the finan- cial crisis of 2007-10, but also the essence of this critically acclaimed film in capturing a sta rtling home truth ; it was an 'outsider'-hedge f und manager Michael Burry (Christian Bale)-who spotted the fragility of the US housing bubble and subsequently predicted the worst financia l crisis since the Great Depression of the 1930s. The film suggests that those in the protected 'inner' cir- cle of banks, real estate agents, and even policy- makers failed to see w hat was coming. Based on Michael Lewis' 2010 book The Big Short: Inside the Doomsday Machine, the Oscar- © Moviestore/Shutterstock nominated drama, w hich w on ' Best Ad apted Screenplay', expertly blends laugh-out-loud com- edy with depressing t ruths about the financial crash. A star-studded cast offer eccentric and colourfu l characters that provide the real source of humour in the film: Michael Burry (Ba le) is the awkward genius who comes to work in shorts and without shoes; Mark Baum (Steve Carell) is the rude, opin- ionated, and outlandish hedge-fund manager who thrives on doom and gloom; and Vennett himself (Gosling) is the astute yet mora lly questionable narrator of the film, who brings the audience into in-jokes w ith witty quips and dry comments. In the face of calamity and disaster, Vennett calm ly comments, 'there's some shady stuff going down...' What's more, poignant cameos bring to life the complex technical backdrop of the story, tackling financial terminology in a light-hearted and acces- sible way. Margot Robbie of Wolf of Wall Street fame, for instance, jocularly explains the sub-prime mortgages w hile sipping champagne in a bubble bath. The story begins with Burry (Bale) making a remarkable discovery that the US market is 'propped up by bad loans'. Rather than bringing in the regulators, he decides to create a credit defa ult swap that allows him to short the housing market and in doing so, provide him with a ticket to a life of luxury. His idea is, however, a slow burner, and amidst angry clients and surges in house prices, Vennett (Gosling) and Baum (Carell) discover that Burry's instincts may, in fact, be correct and they decide to also begin betting against the housing market. It is only when two investors learn of th ese worrying developments that the advice of retired banker Ben Rickert (Brad Pitt) is sought and the moral consequences of Burry's discovery are made known. Profiting from the downfa ll of the US economy might be legal, but it certainly isn't ethica l. CHAPTER 6 Shareholders and Business Ethics 249 While to some the melange of truth and humour in th is film is enticing, to others the film is super- ficial, mocks serious issues, and skates over the true cost of unethical decision-making in the finance industry: 'The Big Short is fatally unsure about whether it is a righteous condemnation of fraud, or a black comic romp with cool amora l dudes and rebellious outsiders' (Bradshaw 2016). In fact, if we look behind the bravado, we see a startling truth about the power of financial institutions, and the individuals w ithin them. This is a story about corporate greed; indeed, even the 'heroes' of this story in the guise of Ven nett, Burry, Baum, and Rickert are money-motivated and are set to rake in billions through their decisions to short housing stocks, at the expense of many. These characters reveal the dark side of Wa ll Street and whi le The Big Short is praised for its factual representation, we are left knowing very little about the catastrophic consequences of economic collapse and those who lost everything as a resu lt of f inancial ris k-taking. It also begs the question: a decade on from the financial crash, has an awful lot changed? SOU RCES Bradshaw, P. 2016. The Big Short review-Ryan Gosling and Christian Bale can't save this overvalued stock. Guardian, 21 January: https://www.theguardian.com/fi lm/2016/jan/21 /the-big-short-review- steve-carell-ryan-gosling-2008-fina ncial-crisis. Scott, A.O. (2015) In 'The Big Short,' economic collapse for fun and profit. New York Times, 10 Decem- ber: https://www.nytimes.com/2015/12/11 /movies/review-in-the-big-short-economic-collapse-for-fun- and-profit. html. https://www. hollywoodreporter.com/review/big-short-afi-fest-review-840022. https://www. investopedia.corn/a rticles/i nvesti ng/020115/big-short-expla ined.asp. http ://sc reenp rism. com/i ns ig hts/a rti cle/wh ich-rea 1-1 ife-peopl e-a re-the-cha racte rs-of-th e-b ig-s hort- based-on. Visit the on line resources for web links to useful sources of information related to this film. bei ng arrested for insider trading, and to prison sentences of 11 years and two years, respec- tively. What's more, in 2013 hedge fund SAC Capital pleaded guilty to insider trading charges an d was met with a $1.8 billion penalty. The ethical assessment of insider trading tends to rely on one or more of the four arguments depicted in Table 6.1. How do these four arguments correspond to the traditional ethical theorie s set out in Chapter 3? Visit the online resources for a suggested response. Whichever way we look at it, the central problem here seems to lie in the question of where to defme the boundaries. After all, every investor tries to receive as much knowledge about a company as possible and analysts of major investment banks would by no means necessarily treat their knowledge as publicly available. A particular problem has arisen from the afore- mentioned fact that many companies remunerate their executives with stock options or shares. 250 PART B Contextualizing Business Ethics Table 6.1 Ethical assessment of insider trading Fairness Misappropriation of property Harm to investors and the market Undermining of fiduciary relationship ):I There are inequalities Insider trad ers use Insider trad ers might The relationsh ips of in the access to valuable information benefit at the cost of tru st and depende nce relevant information that is essent ially the 'ordinary' investors. among sha reholde rs about companies, property of th e firm This erodes trust, and corporate managers leading to a situation involved , and to w hich makes th e market (and employees) are wh ere one party has an they have no right of riskier, and threatens based on managers unfair advantage over access. According to confidence in acting in t he interests the other. Moore (1990) Moore (1990), this has financia l markets. of share holders, yet argues that thi s is the become a common insider tra ding is fue lled w eakest but most ba sis for legal cases by self-interest. Moore common argument involving insider (1990) argues that this is that tends to be used t rading. t he stron gest argu ment against insider t rading. against insider t radi ng. Source: Mo ore ( 1990) These people may use their inside knowledge of the company to decide when to exercise th eir options or sell their shares (and, arguably, it could be irrational to expect them to do otherwise). As a result, such 'acceptable' incentives are difficult to distinguish from 'un acceptabl e' insider trading. Ethical Dilemma 6 presents a typical situation where the boundaries of insider tradi ng might be very difficult to clearly draw. THE ROLE OF FINANCIAL PROFESSIONALS AND MARKET I NTERM ED IARI ES One of the main institutions to bridge the asymmetric distribution of information betw een shareholders and corporate actors is that of fmancial professionals and market intermedi ar- ies. The two single most important types of actors here are accounting firm s and credi t-ratin g agencies (CRAs). The task of these organizations is to provide a 'true and fa ir view'- as they say in accounting-of a company's fmancial situation, or a judgement of the trustworthiness of an investment opportunity. While the 'big three' major CRAs (Fitch Ratings, Moody's Investors Service, and Standard a Poor's Fina ncial Services) are a global oligopoly, even across the ra nge of accounting, audit, assurance, and other advisory functions of th e main accoun ting firms, th e big four of Deloitte, EY, KPMG, and PwC also have an effective oligopoly, at least in term s of providing audit services to large firms. With shareholder value orientation becoming more and more popular over the last few years, the nature of the accounting profession has undergone substantial changes (Mellahi an d Wo od 2002). Rather than certifying the quality of published accounts, today's audits focu s a great deal, not only on statements of past periods, but also on the future potential of the corporati on. This process, sometimes pejoratively termed 'creative accounting', mirrors the demands of a major group of addressees of corporate statements, namely investors. However, th e risk inh er- ent in this process is evident: the discretionary element of auditing existing figures is already quite significant; this is even more the case for projections based on these figures. To ta ke up the expression used above, the ethical challenge for audit firms lies in the fme line between CHAPTER 6 Shareholders and Bu siness Ethics 251 ETHICAL DILEMMA 6 Who cares whose shares? It has become something of an institution; spending quiet Sunday afternoons with your partner's family in the countryside away from the hustle and bustle of city life. The fresh air, green scenery, and slower pace of life contrast greatly with the stresses and strains of the working week in London. Th e contrast seems even more marked since you started working at PharmChemCo (PCC) 18 months ago. You constantly remind yourself that the long hours and big salary are worth it, as are the career opportunities; PCC is one of the biggest pharmaceutical and chemical companies in the world. It has also turned you into quite a successful player in the stock market. Since you were promoted to regional Marketing Director for the North East, PCC has paid a large chunk of your bonuses in stock options. Even w ith a dipping market, this has proved to be an extremely lucrative package, given your success in meeting sales targets and, of course, shrewd investment decisions. This particular Sunday, however, city life is taking its toll. Here you are, sat in front of a roaring log fire overlooking the rolling hills, yet the last week in the office is still playing on your mind. A specia l meeting w as called by one of the vice-presidents for all of the senior managers. At the meeting, it wa s announced that scientists in a leading research lab at a university in the US had discovered some potentially lethal side-effects associated with one of PCC's bestselling herbicides. The report had been confidential to the board of PCC, but an article containing the research was going to be pub- lished in Big Science magazine on Thursday next week. The purpose of the meeting was to inform everybody and to discuss potential strategies to tackle the problem. Consequently, you w ere urged to stay absolutely silent about the research findings, particularly as the likelihood was that this would turn out to be a major news story. Knowing about this makes you uneasy now. For one thing, it is pretty certain that this information will have a major effect on the share price of PCC, as court cases in the US with huge damages are a certainty. Digesting the news in your office after lunch, you had already decided to sell your shares in PCC first thing on Monday-as it is almost certain that the value of your stocks wil l not be the same in the foreseeable future once this news is out. However, you also worry about the impact the news may have on Julia, your partner's mother, who happens to be an Account Manager for a major investment bank. Not only are you aware that she has invested heavily in PCC shares, she has also advised many of her clients over her years in industry-among them managers of major funds-to invest in PCC. You are quite unsure about what you should do. You have a good relationship with Julia and often discuss work debates over lunch. You want to give her advance warning of the news and get in her good books, particularly because you know that she will hear the news soon anyway given her large network. But if you tell her now, you are certain that she w ill sell her own shares (which you rea lly would not mind), but as she is measured by the performance of her advice to her clients, you can be pretty certain that she wi ll also advise her clients to sell. The effect on the share price before the pub- lication of the article cou ld be substantial. Suddenly city life is leaving a bad taste in your mouth and you are torn between staying put and keeping quiet, or making an early getaway back to avoid the in- evitabl e lunchtime discussions. Then again, maybe dropping a small hint w ou ldn't be too problematic? UU ESTIONS 1. What are the main ethica l issues in this case? 2. W ho are the main stakeholders here, and how would you compare the relative importance of their stakes? 3. Explain w hat you w ould ultimately decide and why. 4. Is th ere an ethical difference betw een acting yourself on the information you w ere given and passing this information on to Julia? Is the re an eth ical difference betw een Jul ia acting on th e information for herself and her giving advice to her clients? 252 PART B Contextualizing Business Eth ics presenting a share as a 'faith stock' or repackaging what one would normally simply call a dud or a 'lemon' (Gordon 2002: 1236). Issues of a similar nature have occurred with CRAs, which are seen by some experts as o ne of the main culprits in the fmancial crisis of the late 2000s (Scalet and Kelly 201 2). The pri - mary role of the CRA is to provide a credible assessment of financial products so that investo rs have a better idea about what a fair price for the product would be and what the risks asso ci- ated with that product are. From that perspective, CRAs are a pivotal element in the la rgely deregulated infrastructure of global financial markets. The main question, then, is whether the assessment of the CRA is trustworthy. For many, this is all but proven: since all three of the main CRAs rated the majority of the 'toxic' mortgage-based securities that caused the frn ancial crisis as 'triple A', the best possible rating (Bahena 2009), 'it is beyond argument that rat ings agencies did a horrendous job evaluating mortgage-tied securities before the fmancial crisis hit' (The Economist 2013). 6 Ethics on Screen 6 explored this issue in depth. Even Lehman Brothers had at least an 'A' rating from all three agencies up to the very day before it co ll apsed (Evans and Salas 2009). We might summarize the five main problematic aspects of the frnancial intermedi a ry·s job in terms of the market power of intermediaries, conflicts of interest, long-term cli ent relationships, difficulty to maintain oversight and controls over standards of diligen ce as firms grow in size, and competition between firms (Ballwieser and Clemm 1999). Yet, given the fluid and complex landscape within which many fmancial intermediaries operate, it is perhaps unsurprising to fmd that accounting firms and CRAs increasingly fmd themselves in the ethical spotlight. THE ETHICS OF PRIVATE EQUITY AND HEDGE FUNDS The broad ethical concerns we have discussed already around issues of transparency and sh are- holder control have been exacerbated through the rise of private equity (PE) firms and hedge funds (HFs). PE firms usually invest money from institutional investors and wealthy indivi du als to reach a majority stake in a public company. After then taking the company private, PE firm s may seek to restructure the firm with the goal of generating more cash and achieving the high- est possible value for the company (or the parts of it) when it is retloated (Cumming and J oh an 2014). For example, after Burger King was bought by 3G Capital, a Brazilian private equity firm, in 2010, its number of employees was reduced from nearly 40,000 to less than 3,000 in a quest to reverse its fmancial decline. When 3G took the firm public again in 2012, its stock market valuation grew almost 1000/o in two years (Leonard 2014). There are a host of ethical issues raised with PE (see Nielsen 2008). The most general con cern is that in most jurisdictions, once the company is taken private, there are no longer many ob li- gations for providing public information about the company. While this entails ethical proble ms in itself, there are also other concerns around PE funds having a lack of consideration for oth er stakeholders, most notably employees and earlier investors. Hedge funds are one specific form of PE firm-initially for investing in complex structured fmancial products for 'hedging' risks from other investments, but now operating in a diverse array of financial investments. They too have raised a number of specific ethical concerns. most notably around their 'emblematic' opacity (Donaldson 2008). Transparency issues are CHAPTER 6 Shareholders and Business Ethics 253 particularly pronounced with HFs since these highly specialized funds are structured in such a way that they do not have to report to regulators in the same way as other investment firms, and they do not even fully disclose their strategies to their own investors. Despite fairly good retu rns-and fairy-tale salaries for their managers- HFs have become notorious because of their high risks, unusually low taxes, huge fees for investors, and an obvious potential for mislead- ing potential investors about their performance (Donaldson 2008). It has also been suggested tha t their lack of transparency has a broader social cost because it hides systemic risk (Donald - son 2008). Some commentators have identified them as playing a key role in bringing about the financial crisis of the late 2000s and criticism ensues regarding the ro le of hedge funds in restructuring companies at the expense of jobs and employees. Rece nt technologica l developments are raising further ethical di lemmas in the private equity world. For instance, a 2017 McKinsey report marked fmancial services out as a 'strong digital adopter'; one of the highest sectors fo r adopting and using artificial intelligence (AI), with spending due to proliferate. 7 While the use of machine learning to inform hedge funds decisions is not new, the recent wave of Al fmancial investors or 'robo-investors ' offer a new level of sophistication to asset management by increasingly automating investment deci- sio ns. As Davenport (2017) comments, 'since most frnancial markets are digital, machines can easily determine which investments perform best. Intuition and personal experience in picki ng investments count for little,' raising important questions around the commoditization of fmancial services job roles. It is difficult at this stage to predict what this shift towards automation will mean for corporate governance in a digital world, yet ensuring transparency aro und the 'digita l black boxes' that drive key investment decisions is becoming an area of increased interest. INVEST ING IN A VIRTUAL WORLD Digital technologies are not just shaping the role of investment decisions in the fmance indus- try, but also the nature of money itself. In the last couple of years we have witnessed a growth in cryptocurrency ; digital currencies, such as bitcoin and Ethereum , which use encryption techniques through secure blockchains to allow transactions between two parties. The technol- ogy underpinning these virtual transactions emphasizes the pow erful and disruptive nature of the internet and many have heralded the introduction of cryptocurrencies as a 'major fmancial revo lution ' that offers cost savings and time efficiencies in investing.8 Cryptocurrencies are certainly interesting from a governance perspective. Commentators such as Tapscott and Tap- scott (2016) have considered cryptocurrency and blockchain technology beyond its economic benefi ts, to examine the ethical and societal implications of these virtual forms of currency and related issues of honesty, trust, accountability, and transparency. What cryptocurrency means for the fmance industry is yet to be determined, yet Ethics in Action 6.1 weighs up the arguments for and against such currencies and considers what business ethics looks like in an increasingly digital age. I Cryptocurrency Dig it al cu rrency that uses encryption techniq ues to veri fy secu re transactio ns be- tween two parti es. 254 PART B Contextualizing Business Ethics ' ~.4 ~ Ethics in Action 6.1 Digital currencies: boom or bust? _ , , ~: '.:" '...There's a big industry around bitcoin. People have made fortunes off bitcoin, some have lost money. It is volatile, but people make money off of volatility too...' -Richard Branson, Source: Bitcoin.com. In January 2018 the market for digital or virtual currency know n as 'cryptocurrency' was valued at $830 billion USO. From modest beginnings w ith the launch of bitcoin in 2009 (a cu rrency value d at $190 bi llion USO at the ti me of w rit ing), there are now over 1,500 cryptocurrencies in circulation. Cryptocurrencies are also hitting the mainstream w ith ATMs, brokers, and a w ealth of online 'how to' guides 9 elevating the purchase of cryptocurrency from insider 'techies' to your avera ge Joe. He re w e evaluate the ethical pros and cons of cryptocurrency and consider w hat the future might hold for 'digital gold'. What is cryptocurrency? Let's first define w hat w e mean by 'cryptocurrency.' It w as during the Second World War that cr yp- tography-the art of encrypting information to make it secure-w as born. Today, digital or vi rtua l cur- rencies known as cryptocurrencies use cryptography to verify secure tra nsactions between two par- ties through blockchain ledgers that store all transactions and related information. Anyone can ope n a 'digital wallet', buy cryptocurrency, and use currencies like bitcoin or Ethereum to pay for products and services; the challenge isn't alw ays putting money in, but more 'cashi ng out'. A volati le exchange rate, a variety of options for transferring digital value into physical, 'Fiat' currency, and questions around appropriate storage methods mean that cryptocurrency is often seen as a ris ky investme nt. Yet, to its main proponents, it is exactly this uncertainty that makes cryptocurrencies so appea ling. Cryptocurrency is the future It's not easy to ignore the media hype that surrounds cryptocurrency and particu larly th e 'bitcoin revo lution'. The likes of Kodak have seen spikes in share price following announcements that they will be embracing cryptocurrency, and stories of self-made bitcoin millionaires are commonplace.10 Aside from the hype, the benefits of cryptocurrency broadly fall into three main camps. Fi rst, crypto- currency is more affordable. Market commentators see bitcoin, and its rivals, as offering a 'libe rtar ian dream' in disrupting conventional monetary markets (cash, credit cards, and cheques) and smashin g government sovereignty and the dominance of the world's financial institutions. Cryptocu rre ncies are not subject to the same inflationary pressures of government-supported currencies and thus result in potentially lower transaction fees and more cost-effective international exchanges. As Sha h (2013) comments, 'Imagine a type of money that is virtually untraceable and untaxable and ca n be used by anyone anonymously. It's valid in every country, it can buy anything from computer software to books and your account can never be frozen.' Second, cryptocurrencies are more secure. These digital financial assets work on a networked , peer-to-peer structure, and so they are completely decentralized. This means that ow nership of a cur- rency such as bitcoin essentially entitles you to a collective agreement from everyone on the bitcoin network that your asset was legitimately created. Cryptocurrencies are thus largely based on trust and shared knowledge, with the complex system of algorithms and cryptography that constitute the blockcha in ensuring that the systems surrounding cryptocurrencies are secure. This is appealing to business and governments across the globe. For instance, the US military is experimenti ng with bitcoin blockchain technology to improve cybersecurity, in an attempt to prevent hacking , ransom- ware attacks, as well as tampering and cyber hijackings of vehicles, aircraft, or satellites." From a shareholder perspective, Yermack (2017) comments on how cryptocurrencies offer a more passi ve CHAPTER 6 Sha reholders and Business Ethics 255 or partnership form of governance that changes the balance of power from traditional systems and opens up opportunities to encourage more reliable shareholder voting and reduce insider trading. Third, one of the key upsides of this more affordable and secure currency is that it enables greater financial inclusion. Cryptocurrencies do not need physical branches and this new technology can pro- vide greater access to economically deprived individuals and small businesses who wish to borrow money. These benefits are also extended to humanitarian aid. Automation and digitization provide greater transparency, increasing the chance for money to be received where it is needed, reducing the opportunity for fraudulent transactions and corruption. It is even argued that cryptocurrencies and blockchains can bring greater environmental and social benefit in the shape of better supply chain accounting , more accurate quantification of environmental reporting, and even the develop- ment of green cryptocurrencies that back investment in green causes. What's the downside, you ask? Let's take a look. Cryptocurrency is a bubble Amidst bitcoin price plunges and reports of financial crime in the guise of cryptocurrency theft and fraud, the technological and financial benefit of these digital assets has been called into question. Critics are challenging the 'irrational gold rush' surrounding cryptocurrency and speculative investing, with some commenting that bitcoin is an 'investment bubble'.12 More specifically, concerns revolve around two issues. First is a question of regulation. Given their decentralized nature, cryptocurren- cies are unregulated and subject to manipulation. You do not need to disclose your identity to buy and sel l cryptocurrencies, and this anonymous culture has led many to equate these digital assets with illegal activity on the dark web, money laundering, and tax evasion. A bitcoin backlash is ensuing, with large banks including Bank of America and JPMorgan Chase announcing in 2018 that they will no longer allow customers to purchase bitcoin with credit cards, due to concerns about credit risk. 13 The Chinese government is also looking to block domestic access to cryptocurrency trading from overseas websites, with South Korea looking like the next country to issue a clampdown on bitcoin.14 This all boils down to the second point; cryptocurrencies are risky. While the security of the peer- to-peer model favours some, others are concerned that there is no central repository for the likes of bitcoin and Ethereum; a computer crash or loss of data may result in digital holdings being com- pletely wiped out of a blockchain (assuming that no backup exists). What's more, bitcoin virtual wa l- lets are t ied to particular address 'hashes' (a random sequences of letters), which can be viewed by anyon e who downloads a bitcoin ledger. Tran sparency thus comes at the cost of privacy, it seems. It is also important to remember that these assets, and the technology sitting behind them, is still rather new, being in existence for just over a decade. Our more established, Fiat models of currency have been around for over a century. There is still more to learn from this virtual marketplace, and there have been calls for better training, information, and awareness raising about both the benefits, and risks, of cryptocurrencies. 15 A new digital frontier While cryptocurrencies have benefits including affordability, security, and inclusivity, they are not without risks in this new and unregulated environment. Cryptocurrencies offer much to reflect upon in th e context of business ethics and only time will tell if the li kes of bitcoin really do make it to the mainstream and shape shareholder behaviour, or remain in the shadows. One thing is for sure : digital currency is here to stay. SOU RCES http://fortune. com/2018/01 /03/bitcoin-buy-how-to-cryptocurrency. https://www.forbes.com/sites/bishopjorda n/2017/07/07 /bitcoin-m ii lionai re/#614 f59616261. 256 PART B Contextualizing Business Eth ics https ://www. t h eg ua rd ia n.com/tech no logy/2018/ja n/29/c ryptoc u rre n ci es-b itco in-block cha in-what- th ey-rea Ily-mea n-for-ou r-f utu re. https ://www. wash ingtontimes. com/news/2017 /aug/17 /pentagon-eyes-bitcoin-b lockchain-te chnolo- gy-as-cyb. https://theconversation.com/can-blockchain-technology-help-poor-people-a round-the-w orld-76059. https ://www.forbes.com/s ites/n i kola i k u znetsov/2 017/07 /24/how-e merging-markets-a nd-blockcha in- ca n-bri ng-a n-en d-to-poverty/#b4799694a0c 7 https ://www. th eg ua rdia n. com/tech nology/2 018/ja n/15/shou ld-i-invest-b itcoi n-dont-m r-money-mou s- t ache. https://w ww.bloomberg.com/news/articles/2018-02-08/criminals-are-ditching-bitcoin-for-litecoin-and- dash-study-says. Shah, 0. 2013. In bitcoin we trust The Sunday Times, Ju ly 7: https://www.thetimes.eo.u k/article/ in-bitcoin-we-trust-fhfbt2nn3lz. http ://fortune.com/2018/02/05/bitcoi n-ch ina-website-ico-block-ban-f irewal I. https ://www. b Ioo m berg.corn/news/a rticl es/2 01 8-02-04/why-the-cryptocu rre ncy-wo rl d-is-watch ing- so uth-korea-q u ickta ke. https://www.nasdaq.com/article/know -yo ur-coins-public-vs-private-cryptocurrencies-cm849588. QUESTION Using the ethical theories presented in Chapter 3, consider the main ethical dilemmas posed by cryp- tocurrencies. Does your analysis impact your own thoughts about investing in the likes of bitcoin? Visit the on line resources for web links to useful sources of further informatio n. SHAREHOLDERS AND GLOBALIZATION Globalization has had a crucial impact on the role of shareholders, the nature of their owner- ship, and the scope of their activities. With global equity and fmance markets being prob abl y the most globalized markets, the consequences of this reformed role for shareholders have become increasingly visible. We might think of shareholders becoming players in the glob al arena in four different ways: Shareholders might become directly involved abroad by buying shares of companies in other countries. Shareholders might be involved indirectly by buying shares in a dom estic (or intern a- tional) company that operates globally by selling goods and services wo rldwide. This as- pect has pa rticular consequences for many European or Asian countries where the capital markets are still very nationally focused. Similar to this indirect involvement, but more pronounced, is the role of shareholders in explicitly multinational corporations (MNCs). Investing in such companies makes sh are- holders indirect players in global capital markets, especially if these companies are heav- ily involved in foreign direct investment activities in other countries. CHAPTER 6 Shareholders and Business Ethics 257 Finally, shareholders may become direct players in international capital markets by in- vesting in funds that explicitly direct their money to global capital markets. Significant players in this category are the so-called 'sovereign wealth funds' which we will discuss in more detail later. This differentiation helps us to recognize the particular effects of globalization on the ethica l issues confronting firm relationships with shareholders. The first two instan ces involve stake- holders as actors in certain well-defmed national capital markets. The ethical issues of corporate governance, as discussed above, are therefore similarly relevant for these instances. The two lat- ter cases, however, are special since they involve shareholders in the context of global financial markets. We would define these markets along the following lines : Global financial markets are the total of all physical and virtual (electronic) places where financial titles in the broadest sense (capital, shares, currency, options, etc.) are traded worldwide. If we just recall our definition of globalization in Chapter 1, global financial markets can perhaps be presently regarded as the most globalized markets since they are the least dependent on a certain territorial basis. The main factors leading to globalization are clearly at play here: technological advances mean that, via electronic trading, fmancial markets today are confined neither to certain locations nor to certain time slots (Parker 1998 : 267-72) ; the key political development is the high degree of deregulation of fmancial markets, which makes it possible to talk about one global market rather than many individual places of financia l trade. From an ethical point of view, these developments raise some serious issues, among the most important of which are the following: Governance and control. Global markets raise the problem th at no national government is entitled to govern them (Becker and Westbrook 1998). With regard to financial mar- kets, this means that the allocation of a fundamentally important resource for modem industrialized economies takes place without any serious normative rules other than the 'laws' of supply and demand (Koch 2000: 189-209). This might not sound too much of a problem, but such a lack of governance and control becomes immediately clear if we look at the sometimes negative consequences of global fmancial market transactions. The most recent example of this is certainly the financial crisis of the late 2000s. What initially started in the US very quickly became a global problem for many international banks, since many of the mortgage-based securities were traded globally and assets based on these investments came under pressure all over the world. The spectacular effect of these rapid movements of capital around the globe became most visible in Iceland-a country that initially attracted large numbers of investors in the mid-2000s. When the rapid de- va luation of mortgage-based securities occurred (in which many of the Icelandic banks were heavily invested), it caused the country to undergo one of the most severe fmancial crises ever experi enced by a single economy. National security and protectionism. A specific governance issue has recently arisen with a particular group of investors often referred to as sovereign wealth funds. These are government-owned funds of countries that invest their budget surpluses-three-quarters of which comes from oil and gas revenues-in capital markets worldwide. Among the countries with large funds, apart from Norway ($954 billion), none is governed by a 258 PART B Contextualizing Business Ethics liberal democracy. These include funds held by the United Arab Emirates ($ 828 billi on) , Saudi Arabia ($616 billion), Kuwait ($524 billion), and Singapore ($359 billion). 16 Wh at if these funds invest in companies in North America or Europe for motives beyond the simple maximization of their value? This became a subject of debate in the US whe n a Dubai-based investor was interested in buying a company that-among other thin gs- owned strategic assets such as the ports of New York and New Jersey. International speculation. Global fmancial markets encourage speculation. Specul ation relates to the act of engaging in a risky financial transaction in the expectation th at it will yield substantial benefit. In short, speculation is the art of gambling in the fin an cial markets whereby investors aim to profit from short-term fluctuations in market va lue. This is not an ethical problem; however, speculative movement of capital may have quite significant impacts on real-life events. For instance, fo ll owing the fin a ncial crisis, fears of debt default took hold in Greece in the naughties, following years of govern ment overspend. It came to light in 2010 that complex financial trading instruments, known as 'credit default swaps' (CDS)-a form of insurance policy designed to pro tect aga inst defaults of bonds and other debt-had been used by hedge funds and investment banks to cash in on the speculation surrounding the Greek economy. As investors bet on the likelihood that Greece would default on its debt payments, through speculative CDS trad- ing, the country's fmancial difficulties worsened. This had wider ramifications in Greece, not only in driving down the value of the Euro, but also in introducing significant socio- economic costs, such as loss of income and property. As government officials tri ed to claw back cents from its citizens in the shape of tax increases and addition al auste ri ty measures, there were calls for greater regulation to prevent such market vol atility, par- ticularly when Greece failed to make its International Monetary Fund {!MF) loan repay- ment in 2015. Large asset managers and investment banks, however, remain stead fas t in their conviction that CDS offer great opportunities for market liquidity. Unfair competition with developing countries. While glob al financial markets are stro ngly deregulated and thus capital can flow easily in and out of countries, this is not the case for the markets for goods and services (Hauskrecht 1999). This debate has been exacerbated by recent practices of investment firms in food commodity markets. While commodity 'futures· exchanges (agreements on future deliveries at a fixed price to reduce uncertainty in crop growing) were created to mitigate against the risk of fluctuating commodity prices, many still point the finger at speculative trading for raising food commodity prices in 20 07- 8. Amidst the onslaught of climate change, many argued that such activity placed un nec- essary strain on global food stocks and left millions hungry or facing extreme poverty. This raised important questions about the ethics of betting on food prices. More recently, automated trading systems, which further reduce human intervention in futures markets, have grown in influ ence to now account for over half the volume of futures commodity trades. This means that prices are becoming even more disconnected from forces of supply. With energy, agricultural, and metals futures now generating more than half its net $2. l bn revenue from trading in 2017, 17 Europe has introduced new 'Mif1d' (Markets in Financial Instruments Directive) regulations to set tougher limits on the size of positions traders can hold in commodities, to prevent price distortion. This key market reform affords a greater level of transparency to the financial markets. CHAPTER 6 Shareholders and Business Ethics 259 Space for illegal transactions. As these markets are not fully controlled by national governments, they can easily be used for transactions that would be illegal in most coun- tries. Terrorism, money laundering, international drug trafficking, and the illegal trade of weapons are all substantially aided by global financial markets in their present shape. The problem of tax evasion and fraud through international capital flows to so-called 'tax-havens ', such as Luxembourg, the Channel Islands, or the Cayman Islands, has also risen to prominence in recent years. In 2017, for instance, the Paradise Papers exposed the questionable fmancial activities of multinational organizations and billionaires across the globe. Described as the 'biggest tax scandal of this generation', leaked papers outed the tax dodging tactics of a range of multinational corporations. Whether it be a fictitious off- shore company, extortionate tax refunds, or secretive loan schemes, the paradise papers uncovered the complex yet commonplace activities of the rich, famous, and powerful. The scope of such activity is explored in Ethics on Screen 2 in Chapter 2. REF ORMING CORPORATE GOVERNANCE AROUND THE GLOBE With the rise of global fmancial markets and the subsequent spread of Anglo-American forms of more market-oriented corporate governance, we have seen a flurry of attempts to reform this aspect of economic life in most countries in the world. Often these reforms follow corporate scandals, as was the case of the Sarbanes-Oxley Act in the US in 2002 or the Dodd-Frank Act, again in the US, in 2010. These have led to significant changes in the governance practices of corpo rate America. In contrast to many reforms discussed further in this section, these are man- datory pieces of legislation attempting to reform corporate governance through the improve- ment of internal controls and external reporting mechanisms-the main focus being the avoid- ance of criminal misconduct. Given that many European and Asian companies have substantial business activities in the US, both Acts have had palpable knock-on effects on the rest of the world, as well as in the US (Webb 2006; Bafilemba, Mueller, and Lezhnev 2014). In Europe and many other parts of the world, probably the main way that reform has been addressed is through the defmition and implementation of new corporate governance codes. Codes are defmed as 'a set of "best practice" recommendations regarding the behaviour and structure of a firm's board of directors issued to compensate for deficiencies in a country's corpo rate governance system regarding the protection of shareholders' rights' (Aguilera and Cuervo-Cazurra 2004: 415). The European Corporate Governance Institute lists more than 565 national corporate governance codes, principles, and recommendations that have been intro- duced since 1998. 18 By October 2016, 92 countries had adopted at least one corporate govern- ance code (European Corporate Governance Institute (ECGI) 2019), yet it is important to note that there is no universal standard. Governance reform has very much spread across the world, including to countries with a relatively small number of listed companies, including Albania, Bosnia and Herzegovina, Croatia, Estonia, Kazakhstan, Malta, Philippines, Qatar, and Yemen. Despite such proliferation, some codes, such as South Africa's 1994 'King Report on Corporate Governance in South Africa' (the 'King Code') and its revisions in 2002 and 2009, have been influe ntial as a template for corporate governance for the entire continent (Andreasson 2011). Subsequently, we have seen the emergence of new governance codes in at least 15 countries on the African continent since 2000. 260 PART B Contextualizin g Business Ethics Think about corporate governance codes from the perspective of the intersecti ng domains of law and ethics introduced in Chapter 1. Can such codes effectively shift ethical issues from the grey area of business ethics into the black-and-white certainties of law ? Visit the online resources for a suggested response. The idea of codes is to prescribe 'best practice' standards for corporations so as to help ensure that certain minimal standards of corporate behaviour are met. Typical issues dealt wi th in codes of corporate governance are illustrated in Figure 6.4. The legal basis and the power of these codes vary significantly: while governments and the general public would ideally like to make codes legally binding, industry tends to ad opt a more cautious stance. On the one hand, the general implementation and enforcement of cod es is desirable. Evidence suggests that countries with effective governance systems and cod es in place are attractive sites for foreign investment and economic growth, offering importan t assurances of legitimacy (Aguilera and Cuervo-Cazurra 2004). Codes also offer useful metrics for managers, investors, and regu

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