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Creating Social Accountability Through Voluntary Codes of Conduct 10/5/2012 Copyright © 2012, S. Prakash Sethi 1 S. Prakash Sethi, Ph.D. University Distinguished.

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Presentation on theme: "Creating Social Accountability Through Voluntary Codes of Conduct 10/5/2012 Copyright © 2012, S. Prakash Sethi 1 S. Prakash Sethi, Ph.D. University Distinguished."— Presentation transcript:

1 Creating Social Accountability Through Voluntary Codes of Conduct 10/5/2012 Copyright © 2012, S. Prakash Sethi 1 S. Prakash Sethi, Ph.D. University Distinguished Professor, Zicklin School of Business, Baruch College, The City University of New York And Forrest Mars, Sr. Visiting Professor of Ethics, Politics and Economics Yale University, New Haven CT Prepared for presentation at a Workshop on the Role of Corporations in a ‘World at Risk’ Norwegian Institute of Science and Technology (NTNU) Trondheim, Norway, November 19-20, 2012

2 Globalization, Multinational Corporations, and Voluntary Codes of Conduct Over the last 30+ years, there has been a dramatic increase in foreign direct investments, which reached $1.5 trillion in FDI flows to developed countries increased by 21% between 2007 and 2011 reaching a total of $748.0 billion. During the same period, FDI to developing countries increased by 11% reaching a record total of $684.0 billion. A very large portion of these investments have been made by the institution of large multinational corporations (MNCs). The twin factors of increased FDI and the enhanced role of MNCs have fundamentally changed the process of global economic growth when contrasted with earlier periods of international trade, which primarily focused on exchange of commodities and manufactured goods. Currently, approximately one-third of the world trade consists of intra-firm transactions, i.e., trade among various units (foreign affiliates, headquarters) that make up the increasingly integrated production system of individual MNCs. The global reach of MNCs is further strengthened by their ability to integrate not only global markets but also national production systems. Copyright © 2012, S. Prakash Sethi 2

3 Impact of Globalization and Growing Influence of MNCs Globalization of economic activities has led to an uncoupling of the corporate persona from its local roots and weakened the traditional bonds of loyalty between the home- grown companies and their local communities and countries of origin. There is growing imbalance in the relative bargaining power of national and regional governance authorities. This has led to a decline in social investments that enhance the quality and supply of public goods. Copyright © 2012, S. Prakash Sethi 3

4 Impact of Globalization and Growing Influence of MNCs continued… Globalization has facilitated a vast shift in economic activity among various regions and countries. Production and consumption activities have become highly dispersed around the world. Since labor and physical resources are relatively fixed while capital is largely mobile, MNCs have used their increasing bargaining power to increase their share of the economic output. MNCs have been able to extract a greater share of economic returns while imposing extra costs on producing countries through negative externalities. All other factors of product, e.g., labor in the emerging economies, and physical resources (environment) have shared poorly in comparison. For the foreseeable future, it is unlikely that new regional or global protocols would develop to restore balance between MNCs and national-local governments. Copyright © 2012, S. Prakash Sethi 4

5 A Paradigm shift in relations between MNCs and national-local governments The shifting landscape of national political regimes and MNC’s economic power has brought about a new kind of instability in the political arena that has also created greater uncertainty and enhanced risk in the economic arena. MNCs are facing increasing pressure to respond to societal needs and expectations that were hitherto considered the responsibility of local political authorities and also home- grown economic organizations. One dimension of the resultant instability can be found in numerous and recurrent campaigns – sometime violent and invariably destabilizing – against the operations of MNCs whether they are dealing with resource extraction, e.g., mining for minerals and oil; working conditions and wages for workers in low wage countries; and, pollution and environmental degradation dealing with MNC operations. MNCs have also been blamed for supporting corrupt and repressive political regimes that would help them with continuing their operations. Copyright © 2012, S. Prakash Sethi 5

6 Need for New Responses to Changes Socio-Political Environment MNCs have recognized that this situation is unsustainable. Consequently, they must develop alternative approaches to creating an environment of greater acceptability of their business model around the world. Further pressure for change has also come from two sources: There has been a resurgence of regional and multilateral organizations, e.g., International Monetary Fund, World Bank, and various regional development organizations, that have sought to create regulatory regimes to hold MNCs accountable for some of the negative consequences of their global business operations. Another important element in this context has been the rise of a new class of non- governmental organizations (NGOs) that: are often regional and international in scope; enjoy a large measure of public trust; and, command considerable financial and professional resources with the ability to challenge every aspect of MNC conduct. Copyright © 2012, S. Prakash Sethi 6

7 MNCs Responses to Changing Socio-Political Landscape – Voluntary Codes of Conduct MNCs have recognized the need for a more proactive response to deal with the new socio-political order in a manner that would create a more hospitable environment for their global business operations in a manner that would minimize the pressure for increased regulation while also giving them considerable control over their business activities. This has largely taken shape in the form of voluntary codes of conduct promulgated by individual companies and industry groups, as well other organizations that espouse proactive changes in MNCs’ corporate conduct. Copyright © 2012, S. Prakash Sethi 7

8 Characteristics of Voluntary Codes of Conduct (VCC) Over the last two decades, there has been a plethora of voluntary initiatives by companies, industry groups, and national and regional bodies that call for creating voluntary standards in those aspects of a corporate conduct that are inadequately addressed in prevailing legal and regulatory mandates. A recent study of Sethi International Center for Corporate Accountability (SICCA), using worldwide database of over 1300 corporations has identified literally hundreds of individual company, industry, cross-industry (universal) codes promulgated by both business-oriented organizations and NGOs. Copyright © 2012, S. Prakash Sethi 8

9 Characteristics of Voluntary Codes of Conduct (VCC) continued… These codes have addressed issues that are important to broad segments of society and are aimed at changing corporate conduct to more adequately address issues that are collectively stated as environment, social, and governance (ESG) issues. A voluntary code of conduct consists of a set of activities that the sponsoring organization (SO) commits to undertake. The effectiveness of SO’s responses to society’s concerns depends upon a number of factors: The socio-political environment, public awareness, and the emotional intensity generated by the issue. The dynamics of competition and industry structure in which the company operates. The institutional character, corporate resources, and management style of a particular organization. Copyright © 2012, S. Prakash Sethi 9

10 Private Law Character of Voluntary Codes of Conduct A company or industry-based codes of conduct is in the nature of a “private law” or a “promise voluntarily made” whereby an institution makes a public commitment to certain standards of conduct. The voluntary approach provides the sponsoring organization (SO) with an opportunity to “define” the conditions and “establish” standards by which the SO wishes its performance to be measured. However, in order to be credible, the scope of the code and the SO’s performance must meet an acceptable level of societal expectations. The “private law” character of voluntary codes gives the sponsoring organization a large measure of discretion. The “private law” character, however, does not reduce the obligations of SOs, whether companies or industries. Rather, it increases their burden to ensure that skeptical critics and public-at-large have faith in the SO’s responses and performance claims. Copyright © 2012, S. Prakash Sethi 10

11 Private Law Character of Voluntary Codes of Conduct continued… The nature of voluntariness, and by implication, the flexibility afforded to companies depends on the premise that SOs and their critics share a common interest in improving the underlying conditions of impacted groups and regions. It is also assumed that all parties share a common interest to resolve the underlying issues within realistic constraints of available financial resources and competitive conditions. The success of the system depends on the ability of SOs to create and sustain a high level of transparency and public credibility. It imposes a heavy burden on SOs to create credible systems of governance, performance evaluation, monitoring, and public disclosure. Copyright © 2012, S. Prakash Sethi 11

12 Voluntary Codes concerned with ESG issues Voluntary codes dealing with ESG issues present challenges for both the sponsors and those who would be impacted by their actions. In direct contract to the more traditions codes of conduct by business organizations, ESG-related codes call for the company and industry SOs to voluntarily undertake additional costs to reduce negative externalities, which may adversely impact their overall profitability and competitive stance (at least in early stages). However, the ability and willingness of individual companies to absorb the cost of group- based codes may significantly differ and thus adversely impact their interest in complying with code standards. Copyright © 2012, S. Prakash Sethi 12

13 Positive Aspects of Voluntary Codes From the business viewpoint, voluntary codes provide member companies with mechanisms to develop solutions that are focused, take cognizance of the member companies’ special needs and public concerns, and, are economically efficient. They engender public trust through “reputation effect” while avoiding being tainted for the actions of other companies. This is a proactive stance and perhaps the best of all possible worlds. It provides scope for experimentation and building consensus, and facilitate further expansion of “private law”. However, to be effective, voluntary codes must have a large measure of acceptability from most of the relevant stakeholder groups. They must also fit within the competitive realities of the marketplace and local socio-cultured environment. The same activity may be considered socially responsible at one time, under one set of circumstances, and in one culture. It may be considered socially irresponsible when any of these factors change. Copyright © 2012, S. Prakash Sethi 13

14 Current Status of Voluntary Codes Notwithstanding, the promising benefits from creating effective voluntary codes, their current status is not encouraging in meeting corporate commitments and engendering public trust. Codes are presented as public statements of lofty corporate intent and purpose, but are short on specific content. The lack effective and meaningful monitoring procedures as to verification and public disclosure of a company or industry’s compliance with code provisions. Code compliance is not integrated into organization’s reward structure and operating procedures. Codes are not taken seriously, event within the company or the industry group, by either managers and employees, or member companies. This situation, if left uncorrected, would deprive the business community of an important tool that would enhance corporate credibility and thereby reduce pressure for greater regulatory oversight and mandatory compliance standards. Copyright © 2012, S. Prakash Sethi 14

15 Types of ESG-Related Voluntary Codes of Conduct ESG-related voluntary codes can be grouped into three broad categories Company-based codes of conduct Industry-wide codes of conduct Multi-industry and multi-sector codes of conduct Copyright © 2012, S. Prakash Sethi 15

16 Group Based Codes – Positive Elements The case for an industry or region-wide approach is based on the premise that companies in an industry or region face similar problems, competitive conditions, and external pressures. A number of arguments are offered in support of group based codes. A coordinated approach would be more cost effective. A multiplicity of codes would make it hard for others to compare and evaluate performances among different companies. It would make it difficult for local manufactures to comply with codes from different companies. It would give the participating companies a united position from which to respond to the concerns of their critics and public-at-large. Copyright © 2012, S. Prakash Sethi 16

17 Group-Based Codes - Drawbacks An industry-wide approach is likely to deter a company that is willing to take initiative in seeking more innovative approaches. An industry-wide approach may tempt companies to “collude” against more socially responsive initiatives. Endless discussions, procrastination, and obfuscation may delay any real action indefinitely, which inevitably leads to public ridicule and distrust. The need to keep the largest number of companies in the group pushes performance standards to the lowest common denominator – the companies with the weakest records can force standards down to what they are willing to live with. An industry-wide approach suffers from the free rider problem. Copyright © 2012, S. Prakash Sethi 17

18 Analytical Framework for Examining the Efficacy of Voluntary Self-Regulation A schematic framework is provided in Figure 1. It explains the inter-related nature of sponsoring organizations and their ability to create and implement different types of voluntary codes of conduct. This framework has been developed through our analysis of a number of voluntary codes of conduct promulgated by individual companies, industry groups, and multi-sector and global organizations. This framework suggests that the effectiveness of a voluntary set of principles or code of conduct depends on the confluence of two sets of factors. a) The cohesiveness of the sponsoring group in shared interest in formulating and implementing the voluntary standards. b) The scope and specificity of enumerated standards and the governance and accountability structures established by the sponsoring group to ensure effective implementation, monitoring, and public disclosure. Copyright © 2012, S. Prakash Sethi 18

19 Figure 1 - Confluence of member characteristics and motivations, and the scope of principles and implementations structures in creating effective voluntary codes of conduct Copyright © 2012, S. Prakash Sethi 19 Sector A Highly focused and committed group with shared values, transparent reporting and strong accountability. Examples: Mattel Inc., Freeport-McMoRan Cooper & Gold Inc., Forest Stewardship Council, Chemical Industry’s Responsible care program Sector B Highly Focused Group – But with heavy emphasis on self- preservation. Government measures are lacking in independence and transparent reporting. Examples: International Council of Mining and Minerals(ICMM), U.S. Defense Industry initiative (DII) Sector D Diversified group with unified focus. Standards are vague and aspirational. Relative ineffective governance although somewhat greater transparency and public disclosure. Example: Kimberley Process Certification System (KPCS) deals with the issue of conflict and blood diamonds, The Equator Principles, Extractive Industry Transparency Initiative (EITI) Sector C Highly diversified group, Principles and standards are kept deliberately vague. Governance system is insular and resists external intervention. Transparency in communication is largely rhetorical and insufficient in terms of concrete information. Example: UN Global Compact. Low High Low High So S1 S’ Cohesiveness among sponsoring group members and commitment to the voluntary initiative. Specificity and materiality of the voluntary code provisions and strength of governance and implantation structures. Po P1 P’

20 Cohesiveness of Sponsoring Groups The first dimension(S0-S1) is defined by the number of participating entities, cohesiveness of their purpose, their view of the socio-political environment, and, their willingness to share the costs and benefits of implementing a particular code of conduct. It suggests that the level of cohesiveness invariably suffers with increase in the number of participants and the divergence in their views as to the scope of voluntary principles, method of implementation and monitoring and discipline activities. Copyright © 2012, S. Prakash Sethi 20

21 Nature and Scope of Principles The second dimension(P0-P1) consists of the nature and scope of principles, or specific undertakings that are incorporated in the voluntary principles or code of conduct. As membership becomes more heterogeneous (either in business or region of operation), application specificity decreases, and principles become more aspirational than compliance-oriented. Copyright © 2012, S. Prakash Sethi 21

22 Problems of Adverse Selection and Free Rider Problems Underlying the difficulty in implementing industry-wide, and, multi-company, multi- purpose voluntary codes are the challenges associated with the problem of adverse selection and free rider. The primary driver of adverse selection is the number of participating entities. As the number increases, the likelihood of adverse selection also increases. Cohesiveness and code specificity both decrease as well. Free riders (those unwilling to share costs, but will gladly reap benefits) also increase as cohesiveness decreases, with consequent governance loss. Decreases in code specificity also allow for free ridership. Copyright © 2012, S. Prakash Sethi 22

23 Sector A (P’-P 1, S’-S 1 ) In general, single companies or industries are more likely to possess robust, specific voluntary principles/codes (Sector A). The single company, as a sponsoring organization (SO), is in the best position to create a voluntary code that addresses the company’s conduct in response to external socio- political challenges. The company has a large measure of control as to how it meets its commitments under the code and takes steps to ensure that performance measures are credible to its various stakeholders. The most prevalent examples of these codes are individual company-based codes of conduct, or industry-wide codes where a code of conduct is focused on a specific and narrowly defined set of business practices, has identifiable external critics and the scope of issues is largely under the control of member organizations. Copyright © 2012, S. Prakash Sethi 23

24 Sector B (P 0 -P’, S’-S 1 ) This Group is comprised of companies that are cohesive but face strong external pressures. They profess high commitment to their codes of conduct while keeping code provisions or principles that are vague and loosely interpreted standards. It allows group members to appear to fulfill the standards, while at the same time not costing the business much in the way of operational discomfort. Copyright © 2012, S. Prakash Sethi 24

25 Sector C (S 0 -S’, P 0 -P’) This group is comprised of companies that are quite diverse in character. They also face multiple external challenges and regulatory environments. Voluntary codes in this category tend to be broad-based and that are more germane to common issues faced by entire communities. There is considerable variance of opinion and outlook both within and between groups. Therefore, common purpose is at best described in abstract terms leaving considerable room for differing interpretations and thus skepticism as to the sincerity and commitment of its sponsors. Copyright © 2012, S. Prakash Sethi 25

26 Sector D (S 0 -S’, P’-P 1 ) This group includes organizations belonging to one or more industry groups and geographical/political regions. As such, it faces a more challenging environment in the creation and implementation of a voluntary code of conduct. Voluntary codes in this sector also vary considerably in their effectiveness because of the divergent interests of their members. For example, members of a mature industry group may have greater cohesiveness in their outlook to external challenges than an emerging industry where participating companies might diverge considerably in terms of their exposure to external challenges and their willingness/ability to respond to them in a proactive manner. Free riders are a common problem for this sector. In general, universal codes or voluntary initiatives tend toward more abstraction and generality with increase in group size and diversity. Copyright © 2012, S. Prakash Sethi 26

27 Sector D continued.. The abstract nature of espoused principles becomes necessary because different participants must interpret them differently in light of business conditions, competitive pressures, lack of public trust and credibility in corporate conduct. Therefore, the success of universal codes would depend to a greater extent on its moral and ethical connotations and societal expectations. It would also require that the SO enjoys a high degree of public trust and respect (halo effect); has created a strong and independent governance structure; and is willing to use its public reputation to bolster performance accountability and transparency. It also follows that a failure to create meaningful governance structure and accurate performance reporting would inevitably degenerate these universal codes or principles into empty rhetoric and thus reinforce public distrust of signatory organizations and also undermine the reputation and public credibility of the SO. Copyright © 2012, S. Prakash Sethi 27

28 Pre-Conditions for the Creation and Implementation of Effective Credible Voluntary Codes of Conduct Based on our research and field work in monitoring code compliance, we have identified eight conditions that must be met for an industry-based code to demonstrate measurable and credible compliance with the industry’s voluntary initiative. 1.The code must be substantive in addressing broad areas of public concern pertaining to industry’s conduct. 2.Code principles or standards must be specific in addressing issues embodied in those principles. 3.Code performance standards must be realistic in the context of industry’s financial strength and competitive environment. The industry should not make exaggerated promises or claim implausible achievements. 4.Member companies must create an effective internal implementation system to ensure effective code compliance. Copyright © 2012, S. Prakash Sethi 28

29 Pre-Conditions for the Creation and Implementation of Effective Credible Voluntary Codes of Conduct continued… 5.Code compliance must be an integral part of a management performance evaluation and reward system. 6.The industry must create an independent governance structure that is not controlled by the executives of the member companies. 7.There must be an independent external monitoring and compliance verification system to engender public trust and credibility in the industry’s claims of performance. 8.There should be maximum transparency and verifiable disclosure of industry’s performance to the public. Standards of performance disclosure should be the sole province of the code’s governing board. Copyright © 2012, S. Prakash Sethi29

30 Further Explanation of Pre-Conditions The Scope of coverage would include relevant issues pertaining to sponsoring organization’s activities. However, these concerns would need to be amplified into objective, quantifiable, and outcome-oriented standards. These would allow for uniformity in performance evaluation and compliance assurance. Code principles or standards must be specific in addressing issues embodied in those principles. Code performance standards must be realistic in the context of industry’s financial strength and competitive environment. The industry should not make exaggerated promises or claim implausible achievements. Member companies must create an effective internal implementation system to ensure effective code compliance. Code compliance must be an integral part of a management performance evaluation and reward system. For example, at the individual company level, code compliance must be integrated into the firm’s normal decision-making structure and systems. It should also have the oversight for compliance assurance at the level of corporate general counsel, and preferably with a reporting obligation to a committee of the board of directors, e.g., audit committee, or public policy committee. In the final analysis, the top management of the company must be held accountable for ensuring the company’s compliance with code standards. Copyright © 2012, S. Prakash Sethi 30

31 Governance Structure The industry or universal group must create an independent governance structure that is not controlled by the executives of the member companies, or dominated by the private sector organizations to the exclusion of other important stakeholders whose lives and livelihoods are impacted by the conduct of the member companies and industry groups. An effective governance structure should: a) Allow for a balanced representation of various industry segments and thus minimizes the prospect of any industry segment to dominate decision-making in code implementation. b) Must have independent, external input to ensure that the performance monitoring is not controlled by the same group of people whose performance is being monitored at the company level. The external input in the governance structure does not have to be from the industry’s critics, but from independent experts who have the respect and confidence of all parties involved. c) the fee structure to defray the cost of code implementation must allow for funding that would be sufficient to manage the operations, and will also take into account individual members’ ability to pay. the fee should not be used to allocate decision-making power in the governance structure. Copyright © 2012, S. Prakash Sethi 31

32 Problems with Weak Governance Structure A weak or internally controlled governance structure often yields to members’ pressures to do the minimum by way of code implementation and compliance verification. Lacking internal control and external trust, the system is reduced to an exercise in superficial changes, which are unlikely to carry any weight with the stakeholders whose trust in the code’s sponsors has to be one of its primary goals. It would also result in the erosion in public credibility in the reported outcomes. This phenomenon is also apparent in many other group-based efforts sponsored by multilateral and international organizations, e.g., UN Code of Global Compact, Equator Principles jointly developed by banks and IFC, and the code of sponsored by OECD, and Kimberley Process Certification System (KPCS) jointly sponsored by the United Nations, members states, diamond mining and retailing industries, and non- governmental organizations, to name a few. Copyright © 2012, S. Prakash Sethi 32

33 Independent External Monitoring and Verification The importance of an independent monitoring and verification system is the core element in REGENERATING public trust in any type of voluntary code of conduct. And yet, it is in this area that companies and industries offer the most resistance. It is argued that external monitoring would create an environment of distrust and policing. Companies also fear diluting their reputation with related negative consequences to their business and financial operations. Unfortunately, mere assertions of compliance – in the absence of credible evidence – are unlikely to carry much weight with external constituencies. Copyright © 2012, S. Prakash Sethi 33

34 Transparency and Verifiable Disclosure An equally important element in enhancing public credibility and trust dependence on the transparency and verifiable disclosure of industry performance to the public. Standards of performance disclosure should be the sole province of the code’s governing board. The code sponsors must be willing to make the findings of the independent external audit available to the public without prior censorship. This condition too has faced considerable resistance on the part of companies and industry groups. It is argued that release of such reports would expose those companies to further assaults by their critics, who would not have access to similar information from other companies whose performance may be far worse. Copyright © 2012, S. Prakash Sethi 34


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