May 2007

Thought Leadership Series

White Paper Inside This Issue Corporate social responsibility and a board's accountability to owners Business ethics Risk management Global companies face global challenges Investor responsibility Conclusion

Corporate Social Responsibility Does Good Governance Require It? Open any investor relations magazine or reputable newspaper, scan a wellcrafted annual report or delve into the world of stock market indices and you are sure to find terminology referencing corporate social responsibility, environmental ethics or socially responsible investment. In a competitive global market, the finest positive differentiators can affect a company's bottom line. Allocating owners' capital in search of those differentiators requires constant consideration by a company's board of directors. Globally, boards of directors are evaluating the extent to which social responsibility should be a part of company strategy. The idea is that companies demonstrating that they are socially and environmentally responsible in their activities can garner greater pools of investment capital. The purpose of this white paper is to outline a number of the governance considerations relevant to a corporate social responsibilty strategy. In the second quarter of 2007, the Market Analysis & Access team of the Depositary Receipt Division will publish a follow-on paper which will provide issuers with a comprehensive understanding of the corporate social responsibility market and its impact upon North American investment activity. By Verdun Edgtton Vice President and Corporate Governance Officer The Depositary Receipt Division The Bank of New York

Corporate social responsibility and a board's accountability to owners Social responsibility is not a new phenomenon. The concept has been around for hundreds of years.1 What is more recent is the complexity of issues which a board of directors faces when incorporating a socially responsible strategy into a company's business model. The concept of corporate social responsibility requires a board to take a broader view of parties who might be affected by a company's activities.

At the crux of the issue is a careful examination of one of the legal duties of a board of directors. In simple terms, a board owes a duty to the company's owners to carry out the business purpose for which the company was incorporated and not to deviate from that purpose unless any deviation is in the best interests of the owners. Failure to abide by such a standard may expose a board to claims for breach of duty or other legal consequences. The concept of corporate social responsibility requires a board to take a broader view of parties who might be affected by a company's activities. In the world of corporate social responsibility, stakeholders - parties who are involved in or affected by company activities but who bear no direct and irrevocable residual economic risk - must be assessed when considering business outcomes. This notion is entirely different from the contractarian corporate law perspective where a board has duties only to the company's owners and only owners can hold the company accountable for its results. So, how does a board attempt to reconcile these seemingly competing positions? Defining the business purpose A part of the answer lies in a board divining and communicating the basis of its relationship with the owners. The real work of corporate governance takes place when the board sets goals to meet owners' expectations and ensures that these are achieved. In order for this to occur the business purpose of the company must be known. This may seem elementary. However, a stated business purpose defines the parameters of choices that might be made by a board in effecting the purpose, and lets owners know the realm of activities to which their capital may be applied. For example, a business purpose "to sell goods and services to maximize the owners' long-term value" would exclude any action without a business activity or one that is short-term or unsustainable.

A stated business purpose defines the parameters of choices that might be made by a board in effecting the purpose.

Similarly, a stated business purpose may also provide a board with the flexibility to support activities which complement but do not subvert the business purpose. In that regard, a board can make a decision that at least some forms of socially responsible behavior may actually be consistent with the wealth-maximizing interests of a company's owners.2

1 It was documented in the West in the 17th century where Quakers withheld investing in companies associated with the slave-trade or war activities. See "Screening Investments of Stakeholders: Socially Responsible Investing in the United States", Alec W.B. Petty, 2000 (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=909027)

"Corporate Social Responsibility and Firm Performance: Investor Preferences and Corporate Strategies", Mackey, Mackey and Barney, 2005

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Legitimacy through engagement In order to validate a board's decision to create policy that entails entering into activities involving stakeholders and their interests, a board must link with their owners. This "governance link" places an active and positive obligation on the board to communicate and share strategy with the owners about their expectations and preferences. This becomes particularly important as social, political, and economic conditions change and new management choices have to be made. In this way, a board gains awareness of the sentiment of owners with respect to developing new policy and vests a board with the capability and legitimacy to refine policy to achieve the business purpose.

Business ethics In rationalizing the owner/stakeholder dichotomy, the scope of business responsibilities is deferential to principles of business ethics.

What then are the factors that might guide a board on how a company should engage in socially responsible behavior and address responsibilities to stakeholders? How does a board reconcile both the maximization of long-term value for owners and the importance of stakeholders in value creation? Part of the answer lies in a board determining the values that underlie its policy. In this sense, policy stands for the overarching principles which guide business choices. In rationalizing the owner/stakeholder dichotomy, the scope of business responsibilities is deferential to principles of business ethics. Business choices must be founded upon principles that must be respected for the activity of business to be possible.3 Since the notion of business is presumptively the set of activities which are intended to deliver longterm value for owners, business must be conducted with honesty, fairness (see the discussion below), the absence of physical violence and coercion, and a presumption in favor of legality - collectively, 'ordinary decency'.4 Translating this paradigm into the proper relationship with stakeholders is relatively straightforward - effecting the business purpose is primary but the maximization of owners' value may require the promotion of the interests of other stakeholders. Such promotion may well be relevant to better business by the company and better return for owners. For example, it would not be ordinarily decent to make profits at the expense of low-income employees, as in the case of sweatshop practices alleged against some textile and footwear companies. Well-conducted business should encourage contributions towards the business purpose. Contributions can only be encouraged where there is a proper allocation of benefits for a given contribution. This is an important consideration for a board translating a socially responsible strategy into a course of action. At its core is a set of values covered by the term "distributive justice", which is designed to cover the distribution of benefits and burdens of economic activity.5 The idea is that there should be a fair allocation of benefits relative to the contribution made. This would mean that company employees, wherever they are situated, are fairly remunerated for the work they do. In Europe and the U.S., distributional issues have caused major problems for companies using child labor or substandard wages. Where fairness is absent on a scale, conflict is more likely and its consequences potentially very severe.

"The Stakeholder Concept; A Mistaken Doctrine", Dr. Elaine Sternberg, 1999. Ibid at page 39. 5 Stanford Encyclopedia of Philosophy, http//plato.stanford.edu/entries/justice-distributive. 3 4

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Understandably, a board will always be concerned with the cost/benefit analysis in evaluating whether to allocate company resources to socially responsible initiatives. Economic arguments will likely arise around maximization of a company's future cash flow and therefore definitions of a company's performance. More detailed discussion is likely to address the idea that a company's commitment to socially responsible activities creates a "product" that can be offered by companies to future equity owners as "customers".6

Risk management Understandably, a board will always be concerned with the cost/benefit analysis in evaluating whether to allocate company resources to socially responsible initiatives.

There is also an important risk management component to be considered. One of the key drivers behind companies' serious consideration of socially responsible activities is that conflicts between companies and stakeholders can have cost implications for the company. This manifests itself when a company's interests are not aligned with the interests of stakeholders. In that case, the social cost of a company's behavior can be exploitative relative to a company's internal cost for furthering its business activities.7 A corporate social responsibility strategy is therefore a form of conflict management since minimization of conflicts is likely to reduce the transaction costs of a company in furthering its business purpose. Whether this becomes material is obviously a question of degree. Certainly it is clear that stakeholders can and do penalize a company where stakeholders are not prepared to bear the externalized costs of a company's business activity.8 A board that is aware of potential conflicts and has a risk management tool that anticipates and confronts them is in a far better position to explore alternatives that lessen detrimental impact. Indeed corporate history is littered with examples of companies with hurt earnings and severe share price depreciation on account of neglecting a conflict management strategy. Furthermore, a board's recognition that investors allocate capital based on assessment of risk can make a company more attractive to potential investors provided the board can demonstrate that it can manage risk and articulate the benefits that may follow. Benefits may include improved relations with regulators, better brand equity, lower cost of capital, improved human relations and employee productivity, and reduced waste.9

Global companies face global challenges The globalization phenomenon has changed the way in which companies should view themselves and, indeed, the manner in which society views companies.

For a global company, the challenges presented through the operation of business in international locations are complex. The globalization phenomenon has changed the way in which companies should view themselves and, indeed, the manner in which society views companies. As companies outsource certain activities to lower cost centers, often beyond national boundaries, the network of global suppliers, partners and other alliances inevitably increases. In a similar vein, the global reach of goods and services distribution results in greater sales outside the local market. Issues such as human, labor, and environmental rights are international ones and accordingly social responsibilities can only be characterized as international. As one erudite commentator has observed "…Global corporations now exist in a matrix of norms, organizational interests, and institutional structures that they cannot ignore".10

See footnote 2, page 2. "The Problem of Social Cost", Ronald H. Coase, 1960. 8 Consider thalidomide medication and the subsequent fate of the German drug manufacturer Grunethal or Monsanto and genetically modified crops. 9 "Corporate Social Responsibility - An Economic and Financial Framework", Geoffrey Heal, 2004. 10 "The Responsibility Paradox: Multinational Forms and Global Corporate Social Responsibility", Davis, Whitman and Zald, 2006. 6 7

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Investor responsibility Thus far, the conceptual framework for understanding corporate social responsibility from a company perspective has focused on the approach of a board and its actions. As noted, it is axiomatic that a board has a choice; as the repository of decision rights delegated to it by owners, it has the authority to decide those activities which further the business purpose and are in the best interests of the owners. However, a board's focus and choices are likely to be shaped by the behavior of owners themselves. Companies need to perceive that there is value for them in adopting a strategic focus that has corporate social responsibility as an important component.

In its biannual report The Social Investment Forum highlighted that socially responsible investments rose more than 258% from $639 billion in 1995 to $2.29 trillion in 2005 in the U.S., while the broader universe of assets under management increased less than 249% from $7 trillion to $ 24.4 trillion over the same period.11 It is evident from this type of statistic that the convergence between business issues and larger social concerns is very real and the significance of the dollar amounts is difficult to ignore. The directing of capital to companies with a socially responsible strategy is evidence itself of investors attributing economic value to the way in which business is conducted. The logical corollary is that the allocation of capital can affect the strategic direction and structure of business and the sorts of activities businesses pursue.12 The capacity of investors to allocate vast financial resources to socially responsible companies also comes with exacting responsibility. The efficient development of the global capital markets in this area depends upon sound and consistent screening policies being applied by investors practicing socially responsible investment. Companies need to perceive that there is value for them in adopting a strategic focus that has corporate social responsibility as an important component. If companies are expected to alter their behavior, then their ability to attract capital should not suffer as a result. In the global economy, the competition for resources and generating a return on those resources is great. Proving that socially responsible investment pays for companies requires constructive, realistic, and measured dialogue between a company's board and their investors. If socially responsible investors are to hold a board accountable for its strategy, then those investors must be equally conscientious in their public awareness-raising activities and their broader impact on investment and business pressures faced by companies.

Conclusion The best prepared board of directors is one that constantly tests its interpretations about future influences on the business success of the company. The quality of its foresight will subsequently be judged against established business criteria, the performance of competitors in the relevant sector and current socio-political attitudes. Companies from both developed and emerging markets must be mindful that business success is increasingly influenced by non-financial measures. A coherent strategy around those measures is now a pre-requisite for a successful global enterprise. As markets and investment capital integrate and internationalize, the standards for investment will do the same. Understanding the standards and the investors that apply them is no longer something to be considered by a select few. Good governance and good business suggests that all global companies do so.

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"2005 Report on Socially Responsible Investing Trends in the United States", January 2006 www.socialinvest.org See footnote 2, page 51.

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The Bank of New York Company, Inc. One Wall Street New York, NY 10286 www.bankofny.com © 2007 The Bank of New York Company, Inc. All rights reserved.