To What Extent Does a Company Exist Only For The Benefit Of Its Shareholders - Essay Example

The Occupy protests taking place around the world have highlighted a problem that lies at the heart of corporate structures: the single-minded pursuit of profit at the expense of everything else. Indeed, the logic of the market demands that players in it pursue maximum gain. A company therefore, is expected to pursue maximum profits for its shareholders. Wealth generation becomes a single and overarching focus. Experience has shown us however that this has sometimes led to unfortunate consequences. The single mindedness with which profit is pursued has allowed companies to neglect other issues and concerns. It became of little surprise therefore that the recession that has hit much of Europe and America and the widely-reported corporate scandals have highlighted the need to make corporate governance at the top of a company’s order of priorities and the overriding principle guiding its directors. The escalating protests in Wall Street in the United States, for example, demonstrate growing public outrage against corporate greed and white-collared crimes. In simple terms, this paper suggests that the a company must exist only for the benefit of its shareholders only to the extent that it does not encourage corporate deviance and it retains its obligations to the rest of the society, not necessarily only its shareholders. This paper will argue that instead of wealth generation for shareholders, the underlying principle that should inform decision-making processes of corporations should be the improvement of corporate governance and addressing elite deviance. It will begin by first discussing the Agency theory and its implications. Next it will discuss the theory counterpoised to that, which is the Stakeholder theory – highlighting corners and turns of the debate that theoretically underpins the question as to whether and to what extent a company should exist only for the benefit of the shareholders. Finally, this paper will discuss two specific areas where corporate governance can be better improved. The first is through granting more rights to minority shareholders to bring suit against majority shareholders for prejudicial business decisions and making these rights meaningful in practice and not just on paper. The second is creating more measures against opportunistic and predatory directors to exact responsibility and accountability for fraud. It is hoped that by examining the corners of the policy framework of covering these areas, this paper surfaces issues that need to be addressed and prioritised, thereby proving the necessity of establishing corporate governance as first order of the day before simple wealth generation and maximisation. Background In the United Kingdom, corporate scandals in the United States such as Enron, had at first been dismissed by the UK, believing at first that the mechanisms the latter had in place were enough to exact accountability from errant directors. However, this complacency had yielded when the revelations of corporate greed became more and more shocking. Public trust in capitalism had wavered to a degree heretofore unheard of and soon it became necessary for the UK to revisit its existing measures and determine if these measures were indeed enough. The UK government then embarked on a series of consultations, which resulted in reports that this paper will outline in greater detail later. The reports contained findings on problem areas in corporate governance and some prescriptions. By corporate governance, this paper adopts the definition in the Cadbury Report which defines the phrase simply as “the system by which companies are directed and controlled.” (1992) This definition was extended by the Organisation for Economic Co-operation and Development (OECD) which states that corporate governance “involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders [that provides] a structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined.” Evolution of corporate governance: the doctrine of agency The move to develop the notion of corporate governance and make it apply to corporate enterprises in the United Kingdom began in the late 1980s to the early 1990s, as a result of corporate scandals like Polly Peck and Maxwell. The idea of corporate governance is rooted in the idea of agency. Those who infuse capital into a business enterprise hire managers to run the business for them and see to its day to day affairs. The board of directors and the institutional investors also play a role in the monitoring and control of firms. However, the relationships of these players – to each other and to the general public -- must not be left alone and unregulated. It is imperative that there be well-established rules for companies to follow as they navigate the course of the growth. A concise explanation of the agency theory is articulated as follows: “Agency theory refers to a set of propositions in governing a modern corporation which is typically characterized by large number of shareholders or owners who allow separate individuals to control and direct the use of their collective capital for future gains. These individuals, typically, may not always own shares but may possess relevant professional skills in managing the corporation. The theory offers many useful ways to examine the relationship between owners and managers and verify how the final objective of maximizing the returns to the owners is achieved, particularly when the managers do not own the corporation’s resources. (Bowrin, Sridharan, Navissi, Braendle, The Theoretical Foundations of Corporate Governance)” The problems related to this are also quite clear. Jensen and Meckling had already warned against the “moral hazards” that arise as a result of the situation wherein the managers do not really own shares in the company. Their only interest therefore is maximising their role as much as they can. (1976). In theory, a director, holding as he does a position of trust, is a fiduciary of the corporation. As such, in cases of conflict of his interest with those of the corporation, he cannot sacrifice the latter without incurring liability for his disloyal act. The fiduciary duty has many ramifications, and the possible conflict of interest situations are almost limitless, each possibility posing different problems. There will be cases where a breach of trust is clear, as where a director converts for his own use funds or property belonging to the corporation, or accepts material benefits for exercising his powers in favour of someone seeking to do business with the corporation. To reduce these hazards, Jensen (1983) proposed two important steps: “first, the principal-agent risk-bearing mechanism must be designed efficiently and second, the design must be monitored through the nexus of organizations and contracts.” The problems with erring managers made it necessary for the United Kingdom to undertake mechanism and establish several review bodies to investigate this phenomenon. The first report was the Cadbury report, which came at the heels of the Polly Peck scandal and made several policy prescriptions involving rules for the appointment of directors and composition of the board, the salary of executive directors, internal controls and external audits. After that, in 1995, there was a huge public outcry because of the hefty salaries being given to the directors. The Greenbury report was then commissioned. It took off from the Cadbury report but was the first to introduce the notion of non-executive directors who have no pecuniary interest in the company, would report directly to the stockholders and can make recommendations for corporate governance mechanisms using the vantage point of a disinterested person. The NEDs would, in particular, be in charge of pegging the salaries of the directors, to ensure that the interests of the company would continue to be served and corporate greed be reined in. Following that, the Hempel report which reviewed the Cadbury report and the Greenbury report and came up with the Combined Code. The Combined Code had no binding force but was instead composed of a set of principles, which made recommendations to companies to ensure transparency and accountability mechanisms. In 2002, David Higgs was commissioned to come up with a report on non-executive directors and whether or not a more expansive role was warranted with respect to them. The Higgs report came out with clear recommendations for non-executive directors. They were to meet at least once a year without the chairman or executive directors, such meeting to be recorded and expressly stated in the annal report. The NEDs should conduct due diligence on the board and the company. They shall also exercise power over the recruitment and appointment process, and the nomination committee should be composed of a majority of independent, non-executive directors. Maximising Shareholder wealth vs. Corporate Governance and Stakeholder Theory: Tracing the Debates It is imperative to trace the debates between the competing schools of thought with respect to making shareholder wealth maximisation the primary overriding goal of a corporation. Jensen(2001) has argued with much conviction that this is the “most purposeful, single-valued objective function” and that the furtherance of this goal will lead efficiency. Krishnan(2009) in her work entitled “Stakeholders, Shareholders, Wealth Maximisation”, summarises cogently the shareholder wealth maximisation theory: “This paradigm is built upon the classic competitive markets assumption. Essentially, it is assumed that all participants who have transactions with a firm - employees, suppliers, customers, lenders, etc. - are seen as willing participants in free and competitive markets and are fully compensated at fair market prices for their services/supplies or get fairly valued products/services for the prices they pay. The shareholders are unique because they are residual claimants and they do not have prior explicit or implicit claims. They can add to their wealth only after satisfying all the prior claims of every other participant. They bear all the risk of failure and therefore it is only fair that they get the rewards. The model also assumes that there are no externalities or any harm or damage done to any non-participant in the transactions. Given these assumptions, shareholder wealth maximization is good for not only the shareholders and but also the society.” Proponents of this framework do not see themselves as amoral or unethical – indeed, because all the participants are free and willing, the logic of the market is in fact moral and ethical. This assumption of course traces itself back to Adam Smith, who uttered the famous line, ““By directing that industry in such a manner as its produce may be of greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” At the opposite end of the spectrum is the “stakeholder theory” which is traceable to Freeman (1984) in his book “Strategic Management: A Stakeholder Approach”, and effectively arguing that a company or firm has relationships not only with shareholders, but with other stakeholders. Hence, decision-making processes of the firm should take the interests of these stakeholders into account. A good example would be workers. This means that a corporation has a moral responsibility to ensure that workers are given their due in society, that their wages are decent, their living conditions fair and their right to unionise protected. This is even if it results in diminished profits for the shareholders. Jones and Wicks (1999) called the theory “explicitly and unabashedly moral” as it holds that the interests of all legitimate stakeholders have value, hence it rejects the primacy or prioritisation given to shareholders at the expense of the other stakeholders. This theory received much criticism from those who support the shareholder theory. Sternberg (1999) called it fundamentally misguided, incapable of providing better corporate governance, business performance or business conduct.” Charron (2007) on the other hand, raised fears that the stakeholder theory might be used as a form of corporate control and hamper the free market. Stradding the divide: Merging shareholder wealth generation and fairness and equity This paper argues that there is no need to go pick between two inflexible extremes. Indeed, it is possible to merge fairness and equity into the still-valid imperatives of increasing shareholder wealth and corporate profit. Given the scale of corporate malfeasance and misfeasance, it is difficult to argue now that purely shareholder wealth maximisation is the viable theory. However, hewing too strongly to the shareholder perspective might endanger our capitalist tradition, one of the foundations of our liberal democracy. This paper looks at corporate governance as a frame by which these competing theories might be merged. Protection of Minority Shareholder Rights: A Way of Promoting Corporate Governance whilst still promoting shareholder wealth maximisation If a purely shareholder wealth maximisation approach were used, I argue that this will inevitably mean a protection of the interests of majority shareholders whose voting power is bigger and who can therefore decide the course of a corporation’s business and justify its actions by saying that it is promoting shareholder wealth. This has resulted in the tendency to brush aside other issues and interests. There is no surfeit of examples to demonstrate how minority shareholders and their interests can be prejudiced by the director or those with controlling interests in the corporation. One of the most typical situations of self-dealing is the fixing of directors’ and officers’ compensation. This may take various forms – per diems, salaries and profit-sharing arrangements like bonuses, stock option plans, and the like. Executive compensation in the United Kingdom is typically comprised of the following elements: a base salary, an annual bonus element, and long term pay. Long term pay consists of share options and long-term incentive plans. (Conyon, Peck, Reed, Sadler. 480). In other jurisdictions, as a general principle, directors as such are not entitled to compensation for performing services ordinarily attached to their office, unless the articles of association or the by-laws expressly so provide or a contract is expressly made in advance. In theory, compensation to executives and employees are incentives to greater efficiency. Since the corporation ultimately benefits by this increased efficiency, such forms of compensation would be intra vires, and the fixing of the amount thereof would usually be within the business judgment of the directors. However, abuses may arise where the executives concerned are at the same time directors of the corporation, or have a dominating influence over them. Said Conyon, et. al, “Much of the evidence from empirical work on the determinants of compensation received by top executives has concluded that there is only a very weak statistical link between direct compensation (ie., excluding shareholdings and options) and the market performance of their companies. (ibid.)” What this tends to demonstrate is that errant directors will continue to give themselves lavish salaries and allowances, regardless of profits of the corporations; whilst ordinary shareholders reap benefits only when the corporation profits. Hence, a possible way to go around this is to improve the mechanisms to protect the rights of minority shareholders, with the end in view of limiting the powers of the majority shareholders and improve corporate governance. The Company Act of 2006 has concededly provided a bigger space for minority shareholders. The major purposes underlying the UK’s Company Act of 2006 is to protect shareholder rights, to ensure directors’ responsibility, to promote corporate governance – all of which will, in the end, facilitate a better policy environment for commerce and trade. The Companies Act – previously known as the Company Law Reform Bill -- received its second reading in the House of Lords on January 11, 2006, and received Royal Assent on November 8, 2006. The Act essentially expands the existing derivative action, and allows shareholders to sue the directors for a wider range of breaches, namely in respect of an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust. Another significant change is that a shareholder who has brought proceedings must apply to court for permission to continue the claim. But how then do we ensure a focus on corporate governance rather than maximisation of wealth? To quote Demott (1999: 243): “A central question that underlies many analyses of corporate governance is whether the law and legal institutions have a constituent role in shaping governance practices, or whether the law, as well as governance practices, are best viewed as the inevitable results of market forces, centered upon capital markets. A separate, but related question, is the degree to which mechanisms of governance – such as shareholder voting, take-over bids, independent directors, mandatory disclosure, and shareholder litigation – can function adequately as substitutes for one another.” The move to develop the notion of corporate governance and make it apply to corporate enterprises in the United Kingdom began in the late 1980s to the early 1990s, as a result of corporate scandals like Polly Peck and Maxwell. The idea of corporate governance is rooted in the idea of agency. Those who infuse capital into a business enterprise hire managers to run the business for them and see to its day to day affairs. The board of directors and the institutional investors also play a role in the monitoring and control of firms. However, the relationships of these players – to each other and to the general public -- must not be left alone and unregulated. It is imperative that there be well-established rules for companies to follow as they navigate the course of the growth. In a company, virtually all policy-making is left in the hands of the Board of Directors or on the majority shareholders. While allowing directors to control business strategies has merit – for instance, decision-making is streamlined and businesses largely depend on the need to be able to respond to issues not only with soundness but also with dispatch -- some problems inevitably arise. Instead of prioritising simple wealth generation, efforts must be undertaken towards stricter corporate governance. The desire to ensure the stability of business and protect commerce in the United Kingdom should be balanced by the equally-compelling need to protect the rights of minority shareholders. Though legal and economic conceptions have both rested on and have been shaped by the normative implications of ownership (Grantham, 1998) , it should also be animated by equity and corporate responsibility. For indeed, if what is sought in the long-term is a robust commercial system supported by a legal regime that protects rights, accommodates as many players as possible and will not countenance fraud or breach of duty of those wielding power, then shareholder wealth maximisation will simply not be enough – ensuring the long-term sustainability of the company by an adequate and accountable corporate governance framework is key. References Bowrin, A., Sridharan, V., Navissi, F., Braendle, U. (2011) “The Theoretical Foundations of Corporate Governance.” Available at http://www.virtusinterpress.org/additional_files/book_corp_govern/sample_chapter02.pdf Cadbury Report: The Financial Aspects of Corporate Governance. (1992). Available at http://www.ecgi.org/codes/code.php?code_id=132 Charron, D. (2007) ‘Stockholders and Stakeholders: The battle for Control of the Corporation.’ 27 Cato Journal 1 Conyon, Martin; Peck, Simon; Read, Laura and Sadler, Graham. (2000) “The Structure of Executive Compensation Contracts: UK Evidence.” Long Range Planning 33.478-503. DeMott, Deborah A. (1999) “The Figure in the Landscape: A Comparative Sketch of Directors' Self-Interested Transactions”Law and Contemporary Problems, Vol. 62, No. 3, Challenges to Corporate Governance, pp. 243-271. Freeman, E. (1984) Strategic Management: A Stakeholder Approach. Pitman Publishing Inc. Garrod, N., (1996), Environmental Contingencies and Sustainable Modes of Corporate Governance, Paper presented, Faculty of Economics, University of Ljubljana. Grantham, Ross. “The Doctrinal Basis of the Rights of Company Shareholders.”The Cambridge Law Journal.Vol. 57 (1998).554-588. Higgs Report: Review of the Role and Effectiveness of Non-Executive Directors. (2003). Available at http://www.ecgi.org/codes/code.php?code_id=121 Jensen, M. (2001) ‘Value Maximization, Stakeholder theory, and the Corporate Objective Function,’ Amos Tuck School of Business, Dartmouth College Working paper No. 01-09. Jensen, M.C., (1983) “Organization Theory and Methodology” The Accounting Review, V.LVIII, 2, pp. 319-339. Jensen, M.C., and W.H. Meckling (1976) “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” Journal of Financial Economics, October, V.3, 4, pp. 305-360 Jones, T. and Wicks, A. (2009) ‘Convergent Stakeholder Theory’ 24:2Academy of Management Review 206 Sivrama, K. (2009). ‘Stakeholders, Shareholders, Wealth Maximisation’ University of Central Alabama.Available http://www.abe.sju.edu/proc2009/krishnan.pdf. Miller, Sandra K. (1999) “How Should U.K. and U.S. Minority Shareholder Remedies for Unfairly Prejudicial or Oppressive Conduct Be Reformed?”American Business Law Journal, Vol. 36. No. 3, pp. 318-321. Parkinson, J. (1993). Corporate Power and Responsibility: Issues in the Theory of Company Law. Oxford: Clarendon Press. Reisberg, Arad. (2005) “Shareholders' Remedies: The Choice of Objectives and the Social Meaning of Derivative Actions.” European Business Organization Law Review.227-228. Sternberg, E. (1999) "The Stakeholder Concept: A Mistaken Doctrine." Foundation for Business Responsibilities (UK) Working paper. Available for download from the Social Science Research Network Electronic Paper Collection at: http://papers.ssrn.com/. Read More