To What Extent Does a Company Exist Only for the Benefit of Its Shareholders - Literature review Example

Contemporary Corporate Governance Issues Student’s Name Course Tutor’s Name Date "To what extent does a company exist only for the benefit of its shareholders? Discuss the place of agency theory and its alternatives, including the problems of putting these theories into practice.” Introduction The extent to which a company exists only for the benefit of its shareholders is not clear cut in the United Kingdom or anywhere in the world. For the most part, it would appear that a company’s main responsibility is to give maximum returns on investment to shareholders. However, and considering the increasing calls on companies to be socially and environmentally responsible, shareholder primacy seems to be taking some bargain from managers as they try to join the corporate social responsibility bandwagon. This paper takes a critical look at agency theory and stakeholder’s theory of corporate governance, and observes that in reality, companies exist for purposes of shareholder’s wealth. Realistically however, and considering the social, environmental, and regulatory pressures directed at them, companies have had to consider the interests of other stakeholders. Even assuming that other stakeholders were not a factor in corporate governance, shareholders would still have to grapple with challenges associated with ensuring that managers act in their business interests. Lessons from past corporate failure show that managers (and boards) do not always act to maximise shareholders’ wealth. Overall, this paper ends by noting that it is hard to quantify the exact extent to which a company exists only for the benefit of the shareholders. The extent of benefiting shareholders would however be expected to be greater in companies whose lack of consideration to other stakeholders does not affect operations and/or profit-making potential. Agency theory Legally, the UK company law does not have provisions that impel managers or directors to act in the interest of any other party except for the shareholders. As Spencer (2004, p. 8) notes, shareholders are legally the owners of a company, while the directors just control the same. Additionally, “directors are bound by common law ‘fiduciary duties [duties of faith]’, the most important of which is ‘act in good faith (bona fide) in the best interest of the company as a whole”. While it is not expressly stated that the latter part of the above cited text refers to shareholders, Spencer (2004, p. 8) observes that courts have in the past set a legal precedent where it is interpreted that directors should (for the most part) act in consideration for the best interest of the shareholders, and such interests are often assumed to be maximum profits, which would translate into dividends for the shareholders. The highlighted issues correspond with the shareholder primacy attitude, whereby, the interests of the shareholder are prioritized above the considerations of any other stakeholder. According to Sheirson (2011, p.548) “The conventional view in law and business that corporations are to be managed for the sole purpose of maximising shareholder profits” is largely responsible for the shareholder primacy attitude. Such an attitude is directly related to the agency (shareholders) theory of corporate governance, which follows Milton Friedman’s observations cited by Carillo (2007, p. 97-98), which indicate that the “social responsibility of business is to increase business and consider that shareholders interest in the increase in value of their shares is paramount of corporations goals”. The agency theory of corporate governance implies that the directors and executives in a company are agents acting on behalf of the shareholders, and should therefore use company resources only for the benefit of their principals (Carrillo 2007, p. 98). The agency theory further argues that left on their own, the agents would most likely “pursue their own interests” (ibid.). Chief among the interests that the agents would most likely pursue according to Carrillo (2007) include promoting community interests, something that would enhance their strength and prestige within the beneficiary communities. To safeguard the shareholder’s interest therefore, corporate managers are duty-bound to maximise profits in the companies they manage, and in that pursuit, they can eschew (and can sacrifice) activities or processes that can benefit the society, future generations and the environment (Sneirson 2011, p. 549). Unfortunately, and as noted by Elhauge (2003, p. 3), it is too hard to monitor and/or determine whether managers fully engaged in profit maximisation. This in turn means that shareholders do to some extent have to trust that managers will consider their best interests. Unfortunately, this does not always happen. Problems related to the agency theory Duty-bound or not, relationship problems between managers and shareholders still exist as indicated by Solomon (2010). The problems stem from the conflict of goals between principals and agents; failure by agents to make decisions that are necessarily in the “best interest of the principals”; short-termism (or lack of longevity) by institutional shareholders and managers; and the possibility of managers awarding themselves privileges or bonuses that are self-serving. To eliminate or avoid the problems associated with the agency theory, shareholders can exercise control on the agents, but this too comes with costs on either side. Solomon (2010) observes that shareholders would need to be engaged in the company’s business, they would need to monitor the business, and they would also need to be engaged in audits and management of information and risks. This would ideally mean that shareholders would be taking extra responsibilities to ensure the business is running well, something that they otherwise would leave to the agents (managers) to handle. To the managers, control by the shareholders would mean that they (the managers), would need to prove that they are accountable; would be required to meet with the shareholders; and would be required to report regularly to the shareholders. Even so, and especially where the shareholding is fragmented, there would be no guarantee that the agents would reveal everything that the principals would need to know. A report by the British Broadcasting Corporation (BBC 2013) for example revealed that Barclays Bank had misled shareholders into believing that the £3 billion investment to the bank at the height of the 2008/09 financial crisis was from Sheikh Mansour, while it was in fact from the Abu Dhabi government. By accepting the investment, Barclays is said to have avoided a government bailout, and by so doing rescued other large investments. It is the revelation that shareholders were misled not before the investment deal was approved by the shareholders, but in the 2008 and 2009 annual reports as indicated by the BBC (2013, para. 12) that perhaps illustrates the relative powers and positions that managers have on companies and by extension, on the investors. Stakeholder theory At its very basic, stakeholder theory suggests that companies should pursue interests that go beyond the narrow profit interest of the shareholders, and that the interest of other people who affect or are affected by the activities of a company should be considered too (Carrillo 2007, p. 99). According to Solomon (2007, p. 14), stakeholder theory is increasingly being used in corporate governance as different stakeholders (most importantly the shareholders and managers) understand that companies need to be accountable to a wider group of stakeholders for them to be successful in the long-term. Solomon (2007, p.14) observes that corporate governance is now broadly defined as: “...the system of checks and balances, both internal and external to companies, which ensure that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their business activity”. Stakeholders are on the other hand defined as any individual or group who affect, or is affected by the operations of a company (Carrillo 2007, 98; Brennan & Solomon 2008, p. 886). And according to Sneirson (2011, p. 556), stakeholders are receiving increasing attention from scholars and companies alike. Sneirson (2011, p. 556) observes that while the changes in attention may not indicate an entire abandonment of the agency theory, it is an indication that other considerations other than shareholders are being recognised as deserving some consideration by decision makers in companies. This approach appears essential in contemporary corporate governance since companies have to deal with conflicting interests by people affected by the activities pursued by the companies. As Carrillo (2007, p. 97) notes, one of the main purposes of corporate governance “is to ensure the efficient confluence of otherwise competing interests that are affected by companies’ activities”. On one hand are the interests of shareholders (owners and investors), and on the other hand are the interests of other constituent stakeholders such as employees and members of the community where the individual companies conduct business. According to Solomon (2010, p. 15), a key basis of stakeholder theory is the large company sizes and their pervasive impact in the society, which make it important for such companies to be accountable to other stakeholders in addition to the shareholders. Citing March and Simon (1958), Solomon (2010, p. 15) observes that stakeholder groups “supply companies with ‘contributions’ and expect their own interests to be satisfied via ‘inducements’”. One of the most common approaches to stakeholder theory of corporate governance is corporate social responsibility, which is discussed hereunder. Corporate social responsibility The political and social aspects of corporate governance sometimes force companies to consider other stakeholders other than the shareholders. Using the corporate social responsibility (CSR) concept for example, Spencer (2004, p. 15) observes that companies are increasingly being forced to consider “the interests of the society and the environment when making decisions”. While CSR programmes may appear like indicators of companies’ considerations regarding the larger society and the environment, some critics like Spencer (2004) observe that such programmes are often public relation strategies designed to contribute indirectly to the profitability of a firm. In reality, the critics argue, it wouldn’t matter how well a CSR programme is performing if the profits do not impress the shareholders enough. The critics further believe that if “being good for the society (and the environment)” wasn’t good for “business profits too”, few companies would be engaging in CSR (Spencer 2004, p.15). Even to the non-critics, it is largely agreeable that CSR is a form of “reputation building or maintenance” for companies (McWilliams, Siegel & Wright 2006, p. 4). The need to appear credible and trustworthy to the society indirectly contributes to profitability, especially at a time when consumers and governments are more insistent on supporting companies that are environmentally and socially responsible. Perhaps the reality about CSR is best indicated by The European Roundtable of Industrialists (ERT cited by Spencer 2004, p. 16), which emphasises the importance of reconciling the financial, social and environmental aspects of sustainable development. According to ERT, “profit is a sine qua non for sustained performance” for any company that wants to become a responsible member of the society (Spencer 2004, p. 16). In other words, ERT admits that profit making is still an essential condition and motivation for companies. However, the challenge lies in balancing the profit-making needs of the organisations with other considerations, especially those affecting other people other than the shareholders. Additionally, it is also problematic to ensure that the managers who have been given discretion to act in the interest of multiple stakeholders do not abuse the same discretion for selfish reasons. Solomon (2010, p. 7-8) observes that CSR is more related to ethics than business-mindedness, and as such, he notes that “it is unlikely that businessmen and investors will be interested in acting ethically unless there are positive financial returns to be made from so doing”. Arguably, and in non-subtle terms, CSR is to most companies, a means to profitability, just as is the case with their efforts to adopt stakeholders’ theory. Problems of implementing stakeholder’s theory of corporate governance At the very basic, principals (shareholders) fear that given too much discretion, the agents (managers and executives) would engage in resource diversion and wastage of assets. These fears are fuelled by good reasons, especially considering that the 21st century has witnessed several cases of bad corporate governance that eventually led to corporate collapse with the Enron collapse being a case in point (Carrillo 2007, p. 99). How to control managers and executives while implementing stakeholder theory is therefore a challenge that scholars, regulators and investors alike have to grapple with. Specifically, Carrillo (2007, p. 99) notes that “actions in favour of clients, consumers, workers or even communities at large must be placed under control” in order to avoid instances where wasteful management practices are labelled as good corporate citizenship. When used properly however, it is likely that the stakeholder’s approach to corporate governance would provide the ultimate solution to maximising shareholder’s wealth without neglecting the interests of other stakeholders. As Solomon (2010, p. 20) observes for example, through taking into account the interests of both shareholders and stakeholders, companies operating in the contemporary business environment where social and environmental factors are considered essential, could attain long-term profit maximisation. Ultimately, such would lead to the maximisation of shareholders’ wealth. Pursuing agency theory without considering the effects of the company to other constituents of the society could be self-destructive in the long-term especially if such a company is operating in a sensitive business segment where associations with irresponsible environmental, ethical or social practices would cost it its market share. As Solomon (2010, p. 21) notes, the stakeholder approach to corporate governance seems to be more preferred even by governments and regulators who have in the recent past emphasised the need for companies to be considerate towards employees, suppliers, customers, the environment and local communities. Despite such requirements however, it appears that a gap still exists between the corporate governance disclosures and the reality on the ground, especially considering that the collapse of banks during the financial crises was partly caused by lax behaviour by board members. Solomon (2010, p. 21) notes that banks “revealed immense debts and losses arising from bad risk management practices, excessive risk taking, apparent greed in terms of remuneration and bonuses, and lack of consideration for bank’s shareholders”. How much less would such board members be expected to consider stakeholders (such as employees, customers, and communities) outside their self-seeking interests? Ideally, managers in profit-making companies would be expected to have the interests of the shareholders in both the agency theory and the stakeholder theory approaches, only that the latter would take longer to realise compared to the former. In scenarios where board members and the management in general prioritise their needs over everyone else’s, it would appear that companies do not exist only for the benefit of the shareholders. Conclusion The Barclays Bank example offered elsewhere in this paper is also an illustration that shareholders cannot always understand, monitor or control everything that managers do. As such, there will be cases where shareholders will be mislead, duped, and even at times swindled by the same agents to whom they entrust their investments. From the agency theory and the stakeholder theory, it is also evident that the two approaches to corporate governance pursue the same goal (i.e. profit making) as suggested by Solomon (2010). It is however evident that while agency theory targets maximising profits for the shareholders, the stakeholder theory appears to be geared towards enhancing profits in the long-term by engaging parties that affect or are affected by companies’ activities. Overall, and in consideration of the above discussion, the answer to the question “to what extent does a company exist only for the benefit of its shareholders?” is not definite. The most reasonable answer however would be that the extent depends on whether or not a company still remains relevant when considering the interests of its shareholders only. As indicated in the introductory part of this paper, businesses vary and hence their willingness to consider the interests of multiple stakeholders also varies especially depending on whether or not such considerations affect the businesses’ appeal to the consumer market. Overall, it is worth noting that a lot of scholarly work still needs to be done to determine whether indeed it is possible to genuinely adopt a stakeholders approach to corporate governance. Some of the considerations that future research may need to make include whether or not companies operating in industries such as tobacco can genuinely claim to adopt a stakeholder’s approach, and if so, what and how would they benefit the stakeholders affected most by their businesses (most especially the smokers). It is quite possible that there are no satisfactory answers to such questions especially if some activities by companies are inherently profit-oriented, and thus no actions however good can compensate for the direct and indirect losses or consequences sustained by communities, employees, and the environment as a result. References BBC 2012, ‘Barclays misled shareholders about source of £3bn’, viewed 22 February 2013, . Brennan, N & Solomon, J 2008, ‘Corporate governance, accountability and mechanisms of accountability: an overview’, Accounting, Auditing, and Accountability Journal, vol. 21, no. 7, pp. 885-906. Carrillo, E F P 2007, ‘Corporate governance: shareholders’ interests’ and other stakeholders’ interests’, Corporate Ownership & Control, vol. 4, no. 4, pp. 96-102. Elhauge, E 2003, ‘Sacrificing corporate profits in the public interest’, Presentation at Environment Protection and the Social Responsibility of Firms, Cambridge, Massachusetts, pp. 2-74, viewed 21 February 2013, < http://www.hks.harvard.edu/m-rcbg/Events/Papers/RPP_2-12-04_Elhauge.pdf>. McWilliams, A, Siegel, D S, & Wright, P M 2006, ‘Corporate social responsibility: strategic, Journal of Management Studies, vol. 43, no. 1, pp. 1-4. Sneirson, J F 2011, ‘The sustainable corporation and shareholder profits’, Wake Forest Law Review, vol. 46, pp. 541-559. Solomon, J F 2007, Corporate governance and accountability, 2nd edn, John Wiley & sons, Chichester. Solomon, J F 2010, Corporate governance and accountability, 3rd edn, John Wiley & Sons, Chichester. Spencer, R 2004, ‘Corporate law and structures- exposing the roots of the problem’, Corporate Watch, pp. 1-32. Read More