The European Commission's report about business sustainability puts the business at risk

A recent report by the EU claims that investor-driven short-termism is encouraging firms to return cash rather than invest it, which reduces capital available for investment in growth. Jesse M. Fried and Charles C.Y. Wang show ina a recent article publishe on Les Echos that the data behind the report do not support its claims and argue that if the EU implements the recommendations of the report EU-listed firms will struggle to compete as decision-making slows up and capital gets allocated to questionable ventures.

The Report

The European Commission recently released a sustainable corporate governance report claiming to find a problem of investor-driven short-termism, and proposing as a solution that power be shifted in EU-listed firms to other stakeholders. But the report’s findings are deeply flawed. And its proposed policies would, perversely, reduce business sustainability in the EU.

As supposed proof of short-termism, the report points to rising levels of gross shareholder payouts — dividends and repurchases — and declining levels of investment. The claim: firms are increasingly showering cash on shareholders, stripping them of assets that could be used for long-term value creation. But the report mischaracterizes capital flows, mismeasures investment, and fails to consider firms’ cash balances. The actual data paint a very different picture.

Start with capital flows. Oddly, the Commission’s report fails to account for equity issuances in measuring capital flows between firms and shareholders, focusing exclusively on flows in the other direction — dividends and repurchases. But as we have shown in a recent paper, stock issuances in the EU are substantial, far exceeding repurchases. During 2010-2019, for example, gross shareholder payouts represented 63% of net income. But equity issuances were almost half as large: 27% of net income. Thus, the ratio of net shareholder payouts to net income was 36%, a figure very similar to U.S. public firms.

The report’s conclusion that investment by EU-listed firms is falling is also deeply flawed, but for a different reason: it relies on a cherry-picked sample of public firms. An analysis of all EU-listed firms reveals that both capital expenditures (CAPEX) and research and development (R&D) increased during the period covered by the report, both in absolute terms and relative to revenues (so-called “investment intensity”). Moreover, CAPEX and R&D both increased over the last decade, when shareholder activism has been most intense.

The report implies that investment might be higher had shareholder payouts been lower. But cash balances grew by nearly 40% over the last decade, from €712 to €973 billion. This would suggest that investment by EU public firms is limited by the lack of additional opportunity, not by a lack of available cash. Moreover, even if a particular public firm lacked cash today, the firm could simply issue more equity. That, after all, is why firms go public in the first place. In fact, in each year during the last three decades, smaller EU public firms have absorbed more equity capital from investors than they have distributed: their equity issuances have exceeded dividends plus repurchases.

The Risks

Not only does the report fail to show that EU businesses are misgoverned, it also makes proposals that would actually put these businesses at risk. Most importantly, the report recommends an EU-wide reformulation of directors’ duties to include a broad and ill-defined range of considerations, including representing the interests of the “global environment” and “society at large.” These duties would be enforced by non-investor stakeholders bringing suits in court.

The effect of implementing such proposals would be corporate paralysis. Almost any board decision could be legally challenged by some stakeholder claiming a violation of directors’ almost boundary-less duties. Concerned about personal liability, or even just the embarrassment of being named defendant in a lawsuit, directors will refrain from major decisions without getting buy-in from every stakeholder that might sue them. How will these firms compete with nimble U.S. and Chinese firms? Conducting business through an EU-listed firm will simply no longer be sustainable. Firms will go private, or seek to avoid these rules by domiciling and listing elsewhere.

In fact, the sustainability of Europe’s entire business eco-system would be put at risk. Directors of large listed EU firms would feel pressured to cut back on dividends and repurchases and invest more internally, even if such investments make little sense from investors’ perspective. Capital would be trapped in cash-rich firms and mis-spent. The flow of capital from larger public firms to smaller public and private firms would dry up. Firms looking to raise cash would find it more difficult. After all, why would investors hand funds over to directors whose EU-mandated fiduciary duties now require them to deploy the funds to benefit the global environment and society at large? The question answers itself.

If the European Commission really wishes to increase business sustainability, it should take steps to make it easier, not harder, for European firms to raise, deploy, and return equity capital. It should turn its back on the report’s proposals, which are as poorly-grounded as the findings of short-termism trotted out to justify them.

by Alessio De Filippis, Founder and Cheif Executive Officer @ Libentium.

Founder and Partner of Libentium, developing projects mainly focused on Marketing and Sales innovations for different type of organizations (Multinationals, SMEs, - Start-ups).

Cross-industry experience: Media, TLC, Oil & Gas, Leisure & Travel, Biotech, ICT.