Much has been written about the effect of executive pay incentives on risk taking and corporate ethics in sectors such as banking. Less considered is the effect of “short-termism” and problems with communications between listed companies and shareholders.
Boards that successfully steer the market’s focus towards long-term strategy that is integrated with Environmental, Social and Governance (ESG) goals, and aligned with organisation culture, have a better chance of limiting the effects of short-termism.
A longer-term focus (three to five years), in turn, reduces the risk of unethical corporate behaviour to meet aggressive short-term market demands and targets.
Leading Australian directors have been vocal about the effect of short-termism, where listed companies have excessive focus on short-term goals at the expense of long-term objectives, to meet market expectations.
ANZ Banking Group chairman David Gonksi, AC, FAICD, last year told the Australian Institute of Company Directors’ governance summit there was growing pressure on boards to govern for the short term, even though good governance must have a long-term focus.
There is an obvious link between short-termism and the risk of unethical business behaviour. About 42 per cent of respondents in the 2016 EY Global Fraud survey said they would justify unethical behaviour to meet financial targets.
Almost half of all finance-team members surveyed by EY said they would engage in at least one form of unethical behaviour to meet financial targets or safeguard a company’s survival.
EY wrote: “Worryingly, deeper analysis of our survey results identifies that many respondents who are Chief Financial Officers and finance-team members, individuals with key roles in protecting companies from risks, appear ready to justify unethical conduct.”
Unethical behaviour does not always place businesses at risk of illegal conduct, corporate reputational damage and subsequent enforcement action. But having a minority of executives who are willing to justify unethical acts to improve company performance – partly to meet the market’s short-term demands – is a significant governance issue.
Short-term pressures rising
A recent study by FCLT Global, “Rising to the Challenges of Short Termism”, found short-term pressures on executives and boards had risen since 2013. About two thirds of respondents said pressure on senior executives to deliver short-term results had increased over five years.
Causes of short-termism are complex and inter-related. Greater industry competition, faster information flows and the rise of quantitative (algorithmic) trading programs are increasing market focus on short-term results. Too many investors only focus on the next quarter or half.
Companies are partly to blame. Increasingly, they have set short-term goals and metrics, rewarded short-term decisions and devalued long-term value opportunities, wrote FCLT. Also, company results have been reported and reacted to by the market with a short-term lens.
The market’s obsession with short-term results can encourage some companies to “game” the process: that is, lower investor expectations through investor relations, only to beat the consensus forecast and boost the share price in an unsustainable fashion.
Short-term pressures are likely to grow in the next five years as more money flows into global equity markets through retirement savings, computer-based trading accounts for more sharemarket turnover, and as shareholder activism, via hedge funds and short-selling, grows. The rise of social media is another factor in short-termism.
Australia, thankfully, does not require quarterly reporting for ASX-listed companies, as is the case in the United States. However, there has been a push in some quarters of the investment community for ASX to introduce mandatory quarterly reporting for ASX 200 companies.
The big-four banks already provide quarterly trading updates in between their six-monthly reports and mining companies have been familiar with quarterly reporting for decades.
But that is a far cry from quarterly reporting in the US, which is viewed as a key reason for short-termism, which in turn is a potential driver of unethical executive behaviour to meet earnings targets.
Recasting the conversation
Tim Youmans and Brian Tomlinson, from the CECP Strategic Investor Forum, say boards, management and investors are concerned about the failure of current corporate-shareholder communications to adequately reflect a “long-term” perspective. Their paper, “Far beyond the Quarterly Call”, was published in the Spring 2017 Journal of Applied Corporate Finance.
Youmans and Tomlinson wrote: “There is broad agreement that the dialogue between corporations and shareholders should be re-oriented to address long-term value creation. Corporations that report long-term metrics and provide a consistent stakeholder-oriented, value-creation story tend to attract a higher proportion of long-term focused shareholders.”
The authors say corporate management and investors are caught in a blame game. CEOs complain that not enough investors want to know about long-term strategy. Investors counter that corporate disclosures are geared towards short-term metrics; there is not enough detailed information on long-term strategy for investors to make informed decisions.
Youmans and Tomlinson say companies can break this cycle through a “whole-of-business” approach to long-term strategy. That is, by incorporating ESG metrics and sustainability issues into long-term planning and value-creation, to provide a more holistic view of the organisation.
The communication of long-term financial and non-financial goals, in the context of organisation sustainability, values and ethics, is a powerful proposition. Done well, it helps investors understand the alignment of long-term strategy and culture, and the ability of boards to ensure the right values are embedded throughout the organisation.
That is a world apart from corporate communication that focuses mostly on short-term financial metrics, and is pitched mostly at investment professionals. Encouraging the market to assess the company on a 3-5-year perspective, rather than a 3-5-month perspective, reduces the pressure on short-termism and the risk of executives justifying unethical behaviour to satisfy market demands.
What hasn’t been considered enough is the role of boards in communicating long-term strategy, ESG and culture through market-engagement programs. There is a view in the United States, espoused by governance thinkers such as David Beatty, that boards will need to spend much more time on investor relations as shareholder activism grows. Beatty is adjunct professor and Conway chair of the Clarkson Centre for Business Ethics and Board Effectiveness at the Rotman School of Management.
Challenge of communicating long-term strategy
Communicating strategy sounds good in theory but can be hard to do in practice.
Fund managers, rated on quarterly performance, understandably focus on latest company earnings. The half-year or full-year result helps validate the company’s strategy and creates confidence in management. Also, some institutional investors are reluctant to look too far ahead, given historically high failure rates for corporate strategy.
Some companies are reluctant to project too far ahead with strategy. Continuous disclosure obligations and the risk of shareholder activism have boards treading a fine line between informing the market about long-term plans and raising expectations too high.
The risk of disclosing strategic information to competitors is another consideration. Listed companies often struggle with the trade-off between convincing the market of their strategy and not giving away too much detail to competitors.
Ironically, a growing number of investors have a long-term focus and want to know about long-term strategy and sustainability issues. Superannuation funds, for example, have led a push in Australia for fund managers to incorporate ESG metrics into investment decisions because they recognise financial and non-financial issues affect performance and returns. And that their members are more interested in long-term returns than short-term performance.
Chairmen of large listed companies have responded by spending more time on investor relations with large institutional investors. But boards can do much more to communicate the organisation’s long-term strategy and take some of the focus off short-termism.
Boards that give their organisation the ability to think and act long term in the interests of all shareholders, not just those with a short-term focus, create a potential circuit breaker for unethical behaviour. A long-term focus will never be a panacea to unethical practices, but it is surely better than an unrelenting short-term focus that can lead to reckless acts.