Will shareholders remain at the top of the investment food chain?

For the greater good: Does shareholder primacy maximise social benefits?

Should managers focus first and foremost on profits for shareholders, or should they widen their view to include other stakeholders?

This article is from the February 2016 issue of INTHEBLACK.

By Chris Wright

Is the model that defines modern investment and management broken? For decades, the many managers of listed companies – and the investors who buy their shares – have believed devotedly in the model of shareholder primacy, where shareholders stand above all others.

There is, however, a mounting chorus suggesting that this is an unsustainable way of thinking and that management has to act in the interests of all stakeholders for the greater good.

On one side of this debate is the fact that a company that is working for shareholders is, in a sense, already working for everyone. By seeking to maximise profit, this view says, companies grow the economy, and limits on their economic activity are best imposed from outside, generally by regulation.

“Society and investors have a commonality of interests,” says a discussion paper on shareholder primacy from the Governance Institute of Australia.

This point of view is reinforced by the fact that in many countries, most citizens hold shares, at least indirectly, through their pension schemes. The Superannuation Guarantee, for instance, makes shareholders of most working Australians.

For some years, though, critics have been asking whether that model of shareholder primacy is really the complete answer. The global financial crisis and scandals such as banks’ rigging of LIBOR and VW’s alleged cheating on emissions tests have only increased the questioning.

At the corporate level, in quarterly reporting jurisdictions like the US in particular, are companies properly planning for the long term as they struggle to keep shareholders happy from one quarter to the next?

Ask any of the past few Qantas chief executives if they think their job, running an Australian company with frequent reporting to shareholders, is comparable to that of the executives at unlisted Emirates, who can plan ahead for an entire generation of aircraft without worrying about how it might affect the half-year profits.

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Former CPA Australia chief executive Alex Malley believes shareholder primacy creates problems of short-termism.

“Shareholder primacy has resulted in shorter executive tenure, higher executive remuneration and unacceptable levels of assumed risk with little, if any, positive effect on shareholder wealth,” he says.

Does shareholder primacy maximise social benefits?

In the debate over this issue, each school of thought has plenty of supporters. On one side, with a firm belief in the power and efficiency of the existing system, is Sinclair Davidson, professor of institutional economics at RMIT University in Melbourne and a fellow at Australian public policy think tank the Institute of Public Affairs.

Restating ideas set out a generation ago by the economist Milton Friedman, he tells INTHEBLACK that the shareholder is the rightful claimant to the cash flows of the firm and that it is both natural and fair that the company is therefore managed for them, as long as it stays within the law.

“They are providing the capital and holding the risks of the corporation,” he says. “To ensure that they get some return on their money, they need the company to be run in their interests.”

If this sounds stark, Davidson is not necessarily setting out a them-versus-us arrangement. In his view, a company run this way is best for everyone.

“Generally speaking,” he says, “if you’re trying to maximise the value of the company for a shareholder, you are also selling consumers the goods and services they want to buy in the most efficient manner possible and by maintaining a relationship with the broader community. There is no conflict between the profits for the shareholder and everybody else.”

Professional Development: Setting and managing priorities within the organisation: deciphering priorities

Or does it send us to hell?

At the other extreme is Gordon Pearson, a British expert in management sciences and the author of The Road to Co-Operation. Pearson’s stance is crystal clear in his answer to INTHEBLACK’s first question: where does the pursuit of shareholder primacy take us eventually?

“Hades, probably,” he replies.

Pearson is uneasy about our fate under the current corporate model. He rejects the standard management devotion to reducing costs for the benefit of shareholders, and in particular labour costs, seeing it as unsustainable with a vast and growing global population.

“One can only imagine that a mass-unemployed or poverty-stricken population is going to become violent at some stage,” he says.

“It’s patently unacceptable.”

Yet he says that shareholder primacy is “99 per cent entrenched” in the corporate world. “It’s swallowed hook, line and sinker.”

Pearson is not an anti-capitalist crusader; indeed, he wants more competition between businesses, as well as classic German-style two-tier company boards, with a supervisory level that includes representatives of employees and other stakeholders.

The shareholder model, however, has lost its way in Pearson’s eyes. He points to cases like the sale of 156-year-old British pharmacy chain Boots to US giant Walgreens, which he says led to hundreds of job losses at the UK firm’s operational headquarters in Nottingham.

Pearson has embraced the stakeholder framework developed in the 1980s by corporate philosopher R. Edward Freeman: that businesses do and should respond not just to shareholders but also to employees, customers, suppliers, regulators and many other groups.

The space hero...

In the corporate world, too, there are extremes of views on how devoted one should be to enriching the shareholder.

At one extreme is Bill Anders, whom history will remember chiefly as a crew member on 1968’s Apollo 8 moon mission.

General Dynamics shareholders will remember him for different reasons. As their CEO for three years, Anders explicitly pursued a program of managing purely for shareholders’ interests.

Bill Anders

Bill Anders

When Anders took the CEO’s chair in 1990, General Dynamics had some of the finest research and development expertise in the world for fighter jets, submarines and missiles. It also had haphazard management, US$600 million of debt, negative cash flow, and was considered a candidate for bankruptcy. It made everything from tanks to racing-car carburettors to bricks.

In order to turn the business around, Anders brought in new leadership and tied managers’ bonuses to General Dynamics’ share price – a move that prompted Business Week magazine to dub the company “Generous Dynamics”. He slashed research and development spending and announced plans to lay off 30 per cent of the company’s workforce. Finally, he resolved that the company should sell any business in which it was not the best or second-best player.

Former fighter pilot Anders faced his biggest test during the ensuing asset sales, when Lockheed offered to buy the company’s iconic jet business. He asked for and received a price 50 per cent above his estimate of its value.

“What he did is very revealing,” says John Thorndike, a Harvard Business Review author who uses Anders’ unequivocal position on shareholder primacy as a case study.

“He agreed to sell the business on the spot, without hesitation, although not without some regret. Anders made the rational business decision, the one which was consistent with growing per-share value.”

Shareholders who kept their money in General Dynamics through Anders’ reign got more than six times their money back.

To get that result, Anders was willing to dramatically shrink the company, lay off tens of thousands of workers and turn himself from an American space hero into a corporate anti-hero.

...and the record man

At the other extreme is Sir Richard Branson. Virgin Group was listed in London in the 1980s, when it was a recording company selling the music of bands such as Culture Club. It didn’t take long for Branson to wonder why he’d bothered.

Sir Richard Branson

Sir Richard Branson

He has written that he was deeply uncomfortable with the model that shareholders come first, then customers, then staff.

He thought it should be the other way around.

The pressures of quarterly reporting didn’t fit with his entrepreneurial, sometimes peculative, style of business, and eventually he became so disillusioned that he delisted it (though several Virgin businesses, including Virgin Mobile and Virgin Money, have since been listed).  

Shareholders and the law

Does the law require corporate managers to follow Anders’ example and put shareholders first? Or can they stay public and still behave like Richard Branson?

Answering that is surprisingly tricky. In Australia, for example, the Corporations Act 2001 does not explicitly state that directors have to work for their shareholders; it says they have to act in the best interests of the company, without spelling out what that means. Case law, however, has tended to give primacy to shareholder interests.

Beyond the legal issues, the Governance Institute talks of a “social licence to operate”, which informally protects the company from outside interference. Companies must maintain this informal licence in fields including environmental performance, ethical business conduct, transparency, treatment of workers and community relationships. Yet, as the institute also points out, the idea of a social licence beyond legal requirements simply doesn’t exist explicitly in law. Provided it’s legal, a company is under no obligation to be nice.

Even if the law doesn’t require directors to take a more stakeholder-friendly view, research suggests that they may be doing so anyway. Ian Ramsay, professor of commercial law at the University of Melbourne, says directors themselves are adopting more of a stakeholder approach.

“That’s interesting, because there is a discrepancy between what the law says – by and large, adopting a shareholder primacy model for directors – and what directors are doing,” he says.

Indeed, a study by Ramsay and his colleagues in 2007 asked 4000 Australian company directors to assess how they prioritised shareholders. One question asked was: In whose interests should directors chiefly act? Not one respondent nominated the short-term interests of shareholders only, and just 6.6 per cent nominated the long-term interests of shareholders. A much larger 38.2 per cent said directors should act in the interests of all stakeholders to achieve the long-term interests of shareholders. The majority, 55 per cent, said directors should balance the interests of all stakeholders.

Out in the real world, in other words, Freeman has quietly overrun Friedman. So why is this happening?

“In some respects, it’s a sign of the reality that directors have complex jobs and need to be balancing a range of stakeholders’ needs,” says Ramsay.

“It may be that when a company is flourishing, more often than not you don’t find a dramatic conflict between the actions of shareholders and other stakeholders.”

Ramsay says directors consider themselves bound by numerous other statutes that fall outside the Corporations Act, both at national and state level, and this is typically where they find themselves obliged to think of other stakeholders, on anything from the environment to occupational health and safety.

A further question follows. If companies are supposed to promote practices that serve the greater good as well as the individual shareholder, and if that’s not a matter of law, then who should be accountable for it? Directors, who are ordinarily expected to represent the shareholder? Or government?

Whoever takes charge will find no clear answers: the shareholder primacy debate has come down to a difference of opinion for the best part of a century now, and that’s not about to change.

This article is from the February 2016 issue of INTHEBLACK.

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February 2016
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