Governance 2.0 to deal with sustainability challenges in companies – 03/04/2023 – Why? Economês in good Portuguese

In the last week, some articles were published about changes in Natura’s governance in relation to size, composition of the board and reduction and transparency in executive compensation.

The news caught the attention of many people. In my classes, the most frequent question was: how can an executive receive millions of reais while the company he represents loses value on the stock exchange and the IP&L (Integrated Profit and Loss) does it record around BRL 12 billion negative in the account that lists the company’s impact on initial level consultants?

To answer this question, which is not unique to Natura, on the contrary, it is something very common in the market, I will start by explaining the logic of Agency Theory with regard to executive compensation.

Agency Theory proposes that, due to the growth of companies, decentralization and the separation between ownership and control, it is necessary to develop mechanisms to align interests of agents (executives) with those of principals (owners or shareholders). The argument is that executives have their own interests and seek to maximize them, often making decisions that may be contrary to the interests of shareholders, thus giving rise to what we call agency conflict.

To ensure that the agent’s decisions maximize the value for the principal, two actions can be taken: establishing incentives or variable remuneration for the agent to act in favor of the principal and/or monitoring the agent’s practices. Both generate costs to the principal and can be carried out separately or together.

The logic of variable compensation is that executives would make more effort to improve the company’s results, as this would also contribute to their individual earnings. Therefore, it is necessary to define criteria and goals for performance evaluation, as well as design the variable remuneration system linked to them. In theory, it would make no sense for an executive (agent) to receive aggressive variable compensation if the results for the (principal) shareholder are bad. But this is not always the case.

One of the explanations for this refers to what was agreed in terms of measuring performance and proposing goals for implementing the variable. Poorly designed programs focused on financial and short-term results can benefit one or a few stakeholders.

In addition, in a country like Brazil, where labor charges are high, executive contracts are based on profit sharing programs, given that the variable portion is not considered a complement, which entails less taxes and, therefore, consequently lower fixed costs for the employer. That is, aggressiveness in the use of incentives does not necessarily derive from the need to align the interests of the agent and the principal.

In Brazil, according to research carried out by Michael Page on executive compensation, a CEO could receive between US$ 180,000 and US$ 320,000 in companies with revenues greater than US$ 250,000. In companies of this size, the share of remuneration linked to performance represents 40% to 50% of the total.

Added to this, in the war for available talent, the objectives of a strategic compensation system are to balance the different forms of compensation that help the company attract and retain talent, which can justify such high amounts paid to leadership. In other words, in practice the theory is quite different.

But looking at what has been happening in the market, I dare say that these practices have their days numbered, especially among companies that participate in the movement in favor of sustainability and ESG and are committed to a policy of decent wages and equity for employees .

The wage difference between the base and the top of companies reinforces the social inequality of the society in which we live. The last few decades have been characterized as an inverted income pyramid within companies. Research in the United States showed that the CEO pay gap for a typical worker in 1965 was 20 to 1, in 1989 it was 59 to 1, in 2020 it was 366 to 1, and in 2021 it was 399 to 1.

As sustainability and ESG become better understood by the various stakeholders, public scrutiny can have a significant effect on the reputation and value of companies.

In response, organizations will have to prepare themselves to implement Governance 2.0, whose focus is no longer on maximizing profit for shareholders and high earnings for executives and becomes valuing well-being in a system of relationships with several stakeholders. Purpose and integrity become what align different interests, beyond compliance.

The role of the board becomes crucial in defining the purpose, which must adopt an intergenerational perspective that extends beyond any mandate of the management team. As gatekeeper, the board must decide where and how to place environmental and social responsibilities within the organization’s structure, and how to evaluate performance and reward executives aligned with the purpose. To this end, diversity on the board is fundamental. This is the governance that will ensure the coherence and consistency of sustainability and ESG strategies and practices.

The hope of my students and mine is that the recently announced changes in Natura’s governance will have effects beyond the company’s borders. It is past time for the market to understand that it is not enough to have (some) good and innovative environmental and social strategies if, in practice, governance is oriented only towards short-term profit and for the few.

The main publications on Agency Theory are by Alchian & Demsetz (“Production, information costs, and economic organization”, 1972. The American Economic Review, 62(5), 777-795, 1972) and by Jensen & Meckling (” Theory of the firm: Managerial behavior, agency costs and ownership structure”, 1976. Journal of Financial Economics, 3(4), 305-360).

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