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July 2021

Corporate Behaviour in a Pandemic: Between Legality and Legitimacy

As governments introduced restrictions to economic activity to prevent the spread of COVID-19 infections in 2020, they simultaneously provided support to company balance sheets. Now that economies are reopening, emergency measures appear to have been successful with corporate default rates at multi-year lows. Many businesses remained highly profitable, yet took advantage of this government support. Looking at annual reports, we find that companies have used those profits to pay dividends, with management oftentimes awarding themselves bonuses. While beneficial to shareholders in the short-term, we find a number of reasons why such corporate behaviour could backfire in the long-term.

From restrictions to financial aid

When governments turned to lockdowns to contain the spread of COVID-19 in March 2020, many businesses, forced to shut down, faced strong financial headwinds. To mitigate the economic impact of restrictive measures, the Swiss Federal Council deployed support measures worth around CHF 60 billion. These measures consist of: (1) state-guaranteed loans to provide a liquidity-bridge and (2) an extension of the Kurzarbeit regulation that allows companies to retain their employees, with 80% of the loss of earnings attributable to the reduction in working hours compensated by the state. Both programmes were heavily used: In April 2020, 1.9 million Swiss workers fell under the Kurzarbeit regime, and by May, 117.000 credit facilities were granted. In the four months after April 2020, the government granted a total of 17 billion CHF in bridging facilities alone.
More than a year later, many economies still face heavy restrictions as a result of COVID-19 measures. However, these measures appear to have been successful in keeping companies afloat. Default registry data show that Switzerland saw just 3,811 companies filing for bankruptcy in 2020, representing a 19% decline versus 2019. However, a large divergence could be observed regarding the economic impact of COVID-19 on different sectors and types of businesses. Many businesses, like tech companies, remained profitable, or even benefitted from the pandemic. Along with the anticipation of strong economic growth in the recovery, they now face a bright outlook for the year ahead.

Conditions depend on type of aid & geography

In contrast to the liquidity facilities, the Swiss government decided not to restrict companies that used Kurzarbeit in their ability to pay out dividends. While the Swiss National Council, the Lower House of Parliament, voted in favour, the Council of States, which is the Upper House, blocked the motion. Other countries, such as the Netherlands, prevented domestic entities from doing so, but were unable to legally enforce an international ban.
In the absence of an exogenous shock to the economy, employers and employees usually evenly contribute the lion share to this social security scheme. However, the increased uptake in 2020 and 2021 caused a large deficit. In response, the federal government increased its contribution by an estimated 6 billion in 2021 alone. In that regard, the perception of these measures as a system of joint-insurance has been put in doubt. If it is always one stakeholder that has to bail out the other ones in times of adverse developments, the insurance value of those other stakeholders can be brought into question. Even considering that a part of general tax income comes from corporations, the relative contribution becomes a lot less favourable for consumers. On the other hand, the ability to allocate capital is a fundamental right that should receive high priority in our aim to preserve economic freedom. This includes protection from regulatory infringement. These rights ought to be respected, especially in times of economic hardship.
To spur sustainable growth, a company adds value by allocating its capital to the various major stakeholders of society. An important part of this is the reinvestment of earnings into further development of the business, as it solidifies, or even amplifies future contributions through growth. Other parts are distributed to employees (through wages), the state (through taxes) and shareholders (through buybacks and dividends). Although legal and fiscal conditions vary from one country to another, only a balanced approach to value sharing can be considered sustainable. If this balance is disrupted, it can induce various unwanted side-effects, such as black market activities, tax evasion and corruption.

Legally allowed, but what about legitimacy?

Within the current legal framework, Swiss companies are thus allowed to return their positive result, boosted by emergency measures, to shareholders, thereby essentially re-distributing tax money to shareholders. While this conflicts with the above concept of a sustainable stakeholder approach, it falls within the legal discretion of corporate decision making.
However, the narrative changes when we look at corporate communication. Many companies stress their role in society for the benefit of all stakeholders, and wish to hold themselves to the highest ethical standards. Riding the wave of increased attention for sustainability, companies increasingly claim to benefit society as a whole. This suggests a highly sensitive moral compass, which would ideally translate into congruent corporate decision making.
In that context, we now have an excellent opportunity to observe how those promises hold up. Companies can act on their ambitions to play a role in society that surpasses that of economic profit, and act as a beneficiary for stakeholders, including society as a whole. State-aid that turned out to be unnecessary, could be reimbursed if the company was profitable over that same year and is able to present a strong outlook going forward. Such an act would greatly exemplify aforementioned aspirations and redefine its societal value.
Recent publications of annual reports show a different picture, unfortunately. Companies that made use of COVID-19 aid are now paying out the profits they generated over that same period. Pay-cuts, taken by top management as a token of solidarity, are more than compensated by variable remuneration packages. In many cases, personnel costs have dropped significantly versus 2019, but management still receives variable remuneration, sometimes even on operating metrics that are directly improved through the emergency measures, such as employee retention. In other cases, where listed companies are largely family-owned, the distribution of value among stakeholders becomes even narrower.

How shareholders can help to mitigate

There are three stages at which perceived illegitimate behaviour can be confronted. First, the regulator can avoid the onset by legally obstructing unwanted behaviour. Second, companies can choose to uphold to their moral values by self-regulation. If both of those fail, the asset owner can correct for the behaviour. This can be done through proxy voting and targeted engagement.
This AGM season has provided asset owners with an excellent opportunity to show companies that an imbalance in the stakeholder approach is unwanted. According to the Financial Times, shareholder protests on remuneration packages in the US have reached record levels, confirming this trend. It is encouraging to see investors increasingly take up on this responsibility. In the end, shareholders delegate corporate decision making to management, and place trust in the board to supervise, mitigating inherent agency problems. Observing the use of this discretion in extraordinary times reveals meaningful insights into the functioning of both actors. After all, if a company cannot be trusted to take the ethically preferable decision – especially when it can get away with not doing so – there is no guarantee that the company will not act in a similar way when the parties and stakes are different. This higher uncertainty requires, at the very least, a higher cost of capital. It is through engagement and voting that asset owners through their asset managers can lower this uncertainty, thereby reducing tail-risks in future corporate decision making.
Bank J. Safra Sarasin has developed its own Active Ownership approach, aligned with Bank J. Safra Sarasin’s sustainable investment methodology. We meet with management teams of companies, collaborate with other investors in engagements and exercise voting rights. With over thirty years of experience in the field of sustainability, the Bank’s approach is not only designed to encourage robust corporate governance structures, but also to ensure that the rights of shareholders are protected. Similarly, we encourage and support social and environmental initiatives that, along with greater transparency, aim to produce a positive impact.

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