Is the Shareholder Everything?

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Each side 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. Davidson is also a Senior Fellow at the Institute of Public Affairs, an Australian public policy think tank.

“I stand firmly in the shareholder primacy camp,” he tells IntheBlack. “As in: the best interests of the shareholder are first and foremost. Everyone else is secondary.”

Davidson’s view is that the shareholder is the rightful claimant to the cashflows of the firm, and that it is both natural and fair that the company is therefore managed for them. “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-vs-us arrangement. In his view, a company run this way is best for everyone. “Generally speaking, 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.”

But sometimes there is – these interests don’t always align. “Yes, but the thing is, real life is messy, and people disagree over a whole range of things all the time,” Davidson says. “It’s a case of the institutions of society – of which corporations are a part – organizing what’s in everybody’s best interests and deciding how to carve up the resources that we have.

“The fact that people disagree on how these things should be done doesn’t mean the model is wrong. The underlying principles are right: the rest is just working through the gory details of how we go about doing things.”

At the other extreme is Gordon Pearson, a British expert in management sciences and the author of The Road to Co-Operation. One gets a clear sense of where he stands from his answer to IntheBlack’s first question. Where does the pursuit of shareholder primacy take us eventually? “Hades, probably,” he replies.

Underlying Pearson’s comment is general unease about where our corporate model is taking us. For example, a devotion to reducing costs for the benefit of shareholders, and in particular labour costs, seems unsustainable with a vast and ever-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% entrenched” in the corporate world. “It’s swallowed hook, line and sinker.”

Pearson is not an anti-capitalist crusader and has clear beliefs about amendments to existing corporate models that he thinks can help without damaging the broader economy. One is that protection of competition needs to be reinvigorated. “Governments refer to business but don’t recognise that small, competitive SMEs are very different from the great big plodding predatory monopolists that control most mature markets,” he says.

He would also follow the classic German company structure of a two-tier board,  with a supervisory level that includes other stakeholders, notably employees, in order to entrench them within the decision-making process.

So Pearson is not against the shareholder model per se; he just thinks it’s lost its way. “There’s a hell of a lot of good stuff about shareholding,” he says. “It’s just that it’s open to abuse.” When he looks at, for example, the disposal of Cadbury to Kraft in 2010, in which he says directors were rewarded with a bonus for recommending its disposal despite supposedly representing the best interests of the company; or the sale of 156-year-old British high street pharma chain Boots to US pharmacy Walgreens, leading to hundreds of job losses in the UK firm’s native Nottingham; he sees a system that has gone wrong. “Shareholder ownership has a lot going for it, but the private equity/hedge fund financial sector which is purely and simply oriented to maximising shareholder value is not going to protect the best interests of companies.”

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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 the Apollo 8 mission around the Moon in 1968. But General Dynamics shareholders will remember him for different reasons. During Anders’s three-year tenure there as CEO, shareholders made at least six times their money.

Anders became CEO in 1990. Back then General Dynamics was considered to have some of the finest research and development expertise in the world for fighter jets, submarines and missiles, but had $600 million of debt, negative cashflow, was in a defence industry that was slumping after the Cold War had ended, and was considered a candidate for bankruptcy. It was haphazardly managed. “They had a bunch of businesses that most of the board didn’t even know about,” he says in his home in Washington State. “They were building race car carburettors.” He recalls going to an F-16 assembly plant and seeing a pile of canopies reaching to the ceiling, far more inventory than was required.

To turn the business around, Anders resolved that the company should only be in businesses it was best or second in, and should sell everything else (raising $5 billion of cash in the process). This was fine on the truly non-core assets, but then a real test came. He wanted to buy Lockheed Martin’s iconic Skunk Works business to merge it with GD’s fighter aircraft division; but Lockheed offered to buy him instead.

An accomplished fighter pilot himself, he was loathe to sell the prized division, but saw this as a test of his shareholder value principles. If he was really to stand by his beliefs, he would have to accept a good offer, he thought, so he established the value of the division, multiplied it by 1.5, and gave it to Lockheed, who accepted. “What he did is very revealing,” says John Thorndike, a Harvard Business Review Press author who uses Anders’s unequivocal position on shareholder primacy as a case study now. “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, even thought it shrank his company to less than half its former size.”

So is he Anders asset stripper or a genius who enriched shareholders (among them an astute Warren Buffett)? He was certainly a believer in shareholder primacy.

At the other extreme is Richard Branson. Virgin Group was listed in London in the 1980s, but it didn’t take long for Branson to wonder why he’d bothered. He was, he has written, 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 at all with his entrepreneurial, sometimes speculative style of business, and eventually he became so disillusioned that he delisted it again (though several Virgin businesses, including Virgin Mobile and Virgin Money, have since been listed themselves).

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So who’s right? Answering that is tricky because law tends to be a little oblique on this point. 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, but doesn’t clarify what that actually means – but case law has tended to give primacy to shareholder interests.

The Governance Institute talks of the idea of a ‘social licence to operate’ – what it calls “stakeholder perception of the legitimacy of a company”, or in other words something different from a legal permit but a sense of social legitimacy. We might break this down further into environmental performance, ethical business conduct, transparency, treatment of workers (both in terms of their safety and their broader rights), and community relationships. But, as the Governance Institute also points out, the idea of a social licence doesn’t exist explicitly in law, beyond things like environmental statute. Provided it’s legal, a company is under no obligation to be nice.

But 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 is Professor of Commercial Law at the University of Melbourne. “What we’re seeing is that directors themselves are adopting more of a stakeholder approach,” he says. “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.”

Indeed, a study by Ramsay and his colleagues once approached 4,000 Australian company directors to try to assess how they prioritised shareholders. The results were revealing. In particular, one question asked what they saw their primary obligation as being, in terms of whose interests they should chiefly act in. None said the short term interests of shareholders only; only 6.6% said the long term interests of shareholders only; 38.2% said the interests of all stakeholders to achieve long term interests of shareholders; and the majority, 55%, said balancing the interests of all stakeholders.

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,” Ramsay says. “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.” The makes it easier to balance creditors, employees, suppliers and the rest of the community.

Ramsay says directors consider themselves bound by numerous other statutes that fall outside the Corporations Act, both at a 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 promoting practices that serve the greater good as well as the individual shareholder is perceived as the way forward, and if that’s not a matter of law, then whose role is it? Directors, who are ordinarily expected to represent the shareholder? Or government?

Whomever takes charge, they will find no clear answers: the shareholder primacy debate has comes down to a difference of opinion for the best part of a century now, and that’s not about to change. It may all come down to common sense.

BOX:

It is common to blame shareholder primacy for a host of corporate misbehaviour; right now in Europe, the question is being raised about Volkswagen, which created software designed to cheat emissions tests, thus generated falsely environmentally benign results and hence boosting sales.

Nobody interviewed in this piece thought VW was purely about shareholders; Davidson says it’s a “crony capitalism issue”, and Pearson says he would be “dubious about tying VW back to shareholder primacy,” though he says primacy “certainly begets the sort of behaviour to extract value for the sake of the shareholders at the cost of the company and all other stakeholders.”

Ian Ramsay, the Harold Ford Professor of Commercial Law at the University of Melbourne, believes a better example is banking behaviour through the global financial crisis. “One school of thought is that the banks were too heavily focused on the needs of their shareholders. Another is that the problems were caused by extraordinary short-term remuneration arrangements for senior management. Either way there was a perceived need to be managing, at all costs, the profitability of the financial institutions.”