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Comparative Corporate Governance

How can one be morally bound to an agreement to ignore one’s other moral obligations?

In other words, why should the ‘moral obligation’ to ‘keep a promise’ to maximize shareholder wealth be any more important, or supersede, basic human principles, such as avoiding harm to others?[2]

The above mentioned argument gave rise to a new theoretical framework of ‘agent-morality’ or ‘corporate social responsibility’ or ‘stakeholder theory’ (which says that a manager’s duty is to balance the shareholders’ financial interests against the interests of other stakeholders such as employees, customers and the local community, even if it reduces shareholder returns) in the modern Anglo-American version of corporations where the societal norms are clearly in sync with the shareholder theory (which says that managers primarily have a duty to maximize shareholder returns) i.e. where the criterion of success is shareholder value.

The ‘agency/shareholder theory’ has for a long time represented the dominant paradigm for businesses (Shankman, 1999). Indeed, many of the U.S.economists or those connected to the financial markets accept the shareholder theory’s presumptions conclusively. However, the stakeholder theorists smell blood. Evidenced in the scandals at large organizations, are the concerns about the integrity and independence of accountants who are responsible for auditing financial statements, and issues about the incentive schemes and shareholder recommendations at some of the leading stockbroker and investment banks have all provided essential nutrients for those who question the premise of shareholder dominance. These scandals can be considered as a proof of failure of the shareholder theory and the success of stakeholder theory. However, before declaring a clear winner, it is wise to take into account the working and effectiveness of the two theories.

The Shareholder Theory:

According to the shareholder theory, the basic idea is that the management must work towards the interest of the company’s shareholders and their primary objective is shareholder wealth maximization. The company law does not provide a clear answer to the question: Who should be treated as the ultimate benefactor and in whose interest should the modern corporation be administered? While in theory it’s always been said that the firm must be run in the interest of its shareholders, it says further that the corporation exists as “an artificial person, who may maintain a perpetual succession, and enjoy a kind of legal immortality.”(Blackstone)[3] Therefore, the management of the corporation has a fiduciary obligation to shareholders in the sense that the functions of the firm must be conducted in the interest of the shareholders. And shareholders can theoretically bring suit against the management or specifically the directors of the firm for deviating from working in the interest of the shareholders. But since the corporation is an artificial and legal person, existing only in contemplation of the law, directors of the corporation are constrained by law.

In this century, however, the law has evolved to successfully restrict the pursuit of shareholder interest at the cost of other claimants in the firm. It has, in effect, required that the claims of employees, suppliers, local communities and customers, , , be taken into account, though normally they are subdued to the claims of shareholders.

 

The Stakeholder Concept:

A basis of stakeholder theory is that companies are so large, and their impact on society is so pervasive that they should discharge an accountability to many more sectors of society than solely their shareholders. [4] Freeman and Reed (1983) distinguishes two senses of stakeholders. The “narrow definition” includes those groups who are vital to the survival and success of the corporation. The “wider-definition” includes any group or individual who can affect or is affected by the corporation. [5]  Stakeholders may include one or more of the following: shareholders, employees, NGO’, investors, creditors, suppliers, competitiors, customers, local community, the general public.  Indeed, Wheeler and Sillanpaa (1997) have emphasized on the need of developing  stakeholder society and highlighted the importance for companies to be liable to a wide range of stakeholders.

Linked to the stakeholder theory is the idea of corporate social responsibility which has been defined as:

“The continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as the local community and society at large.”

-    World Business Council for Sustainable Development (2000)[6]

Story behind the disagreement:

As many theorists have observed, the stakeholder perspective has long been existing in the U.S. economic system. Previously, John Cassidy in the New Yorker argued, “Many chief executives saw their main task as overseeing the welfare of their employees and customers. As long as the firm made a decent profit every year and raised the dividend it paid its stockholders, this was considered good enough.”[7] But it is also evident that, in the past two decades, expectations have changed.

A lot of people would wish that the shareholder-stakeholder dispute simply disappears. Particularly, many shareholder theory activists would immediately claim that the theories actually converge, that our society’s norms clearly favor the shareholder theory or that market forces and the law leave one with no other option but to accept that theory. However, none of these claims can survive logical scrutiny.

If we consider the assertion that the theories converge, that if managers take care of the stakeholders, they will wind up maximizing profits and shareholder returns in the long run. However, that is clearly not the case in all situations.

Think about a business in a small town which has many long-term employees and has been manufacturing its products for over thirty years. Those products have been exported to a wide range of foreign markets except for the USAsince the last ten years. After thorough discussions and meetings between its senior executives, they have finally made a decision to its executives have recently concluded to outsource the manufacturing from another country as it would be cheaper and they can no longer afford to manufacture domestically. The shareholder theory would support shutting down the plant and would direct the executives to provide only what the law requires to the employees and the community at large, since there is little possibility of criticism against the company due to a plant shutting down (because the products are mainly meant for export). To spend any corporate funds on re-training affected employees or on aiding to the community would mean squandering away the shareholders’ money, since the investments would never be paid back. However, the stakeholder theory would deduce a regulatory duty to the community as well as the employees; while it might not insist that the company should continue operating the plant, it would expect some efforts to re-train the employees, aid the community in attracting new industries etc. Clearly, these efforts would minimize the profitability, but the stakeholder theory will not support a “retrench and run” approach to the situation.

Additionally, consider the assertion that companies have no other option but to abide by the shareholder theory, depending on the market forces and law. Although there have been instances due to which one can say that U.S. law respects the supremacy of shareholder benefits, however, study of legal statutes do not, by and large, support that assertion. Jay Lorsch states that two principles form the nexus of directors’ legal responsibilities: a duty of care and a duty of loyalty. The duty of care simply means that directors should gather necessary information before making decisions; the duty of loyalty means that directors should be careful to act appropriately when there are conflicts of interest.[8] As noted by Richard Ellsworth, “As long as directors fulfill their dual duties of care and loyalty, courts do not challenge their decisions,”[9] even if they are made according to the stakeholder theory. More specifically, in at least 38 states, there are now ‘stakeholder’ laws, which permit (or even require) directors to consider the impact of their actions on constituencies other than shareholders.[10]In addition, courts in Delaware — where the majority of large U.S. corporations are incorporated and where laws are largely consistent with the shareholder theory — have begun “to liberalize their interpretation of the state’s laws.”[11]

‘Balance’ is the solution:

In my opinion, the function of Corporate Governance and other policies is to boost the status of the corporation in the eyes of the stakeholder.

People invest in companies with a good reputation and it is common sense that if a company does not have good governance it won’t have a good reputation.

Certain reports have shown that reputation can account to more than 50% of a company’s share value (intangibles). Thus the association must become apparent. Reputation is derived from the way stakeholders perceive the organisation.

Therefore, a stakeholder performance framework becomes a tactic for an organisation that recognizes that there is value in relationships which needs to be explored.

Corporate Reputation has a number of drivers which govern it, such as, emotional appeal, vision & leadership, social responsibility, financial performance etc.

The idea of reputational risks reduction is to consider and work with a range of stakeholders in each of these driver areas in order to identify potential loopholes and suggest how to deal with them. It won’t be a surprise to find that different stakeholders regard certain of these drivers more important than others. However, managers can concentrate on only some of these driving areas, and that is the danger. As Warren Buffet, while taking control of Salomon Brothers following the Treasury notes scandal in the early 1990s, famously fired all those involved and said to those who remained:

“If you lose money for the firm by bad decisions, I will be very understanding. If you lose reputation for the firm, I will be ruthless.”[12]

It is thus about relationships, not only with the shareholders but with the stakeholders as well and making sure that you realize the needs of all the stakeholders and can communicate and build a relationship with them.

Every resolution or choice that a corporation must make has 4 broad sets of entailments. The obvious three sets of entailments are financial, legal and operational.

The fourth set of inference is mostly disregarded, further assigned or included in the process only on the basis of the inherent aptitude of one of the partakers. This fourth set of entailment is “reputational”.

The reputational implications of a business decision can be identified as those that affect the way in which a corporation is regarded by those with whom it interacts, including shareholders, customers and employees, as well as suppliers, government regulators, the media and even competitors etc.

Any corporation is dependent on its stakeholders for support and the strategic significance of any stakeholder depends on how dependent the corporation is upon it. And this relationship can change in due course of time or due to recklessness.

Maintaining a corporation’s status needs to be more holistic than just Corporate Governance, and needs to consider the company’s relationship with consumers within the environment of a range of relationships, any of which may, in certain instances, go beyond the bond with shareholders, consumers or any other stakeholder in priority.

Directors must calculate a company’s risk management route. Risk can be defined as uncertain potential events that could affect the achievement of a company’s objectives such as strategic, legal, operational and financial issues. (King Report on Corporate Governance)

King points out: “This broad view of risk encourages a focus on vigorously administering risk that should be taken in the pursuit of opportunity, as well as focussing on shielding the company against redundant or avoidable losses. Risk goes to the very core of a company’s capability to meet its goals and maintain its existence”. The management of corporate status has become a priority, worldwide, on many progressive companies’ agendas. Indeed, a recent survey in Europe has revealed that a company’s reputation is one of the 3 most serious issues on any CEO or corporate agenda.

The progressive companies in today’s world have realised that reputation is an asset that ought to be managed, pro-actively. Organizations have finally realised that the scrutiny under which businesses function today, and the amount of information in the hands of consumers and the outside public, make status a fundamental asset, and in some industries the most significant. [13]

Essential decisions by stakeholders are ever based on trust. Good reputations are built on good behaviour and policies that bring in stakeholder’s trust. Before there is any communication, there must be reputation matter. If you analyze your own role as a stakeholder with other corporations, you will realize that trust is at the very centre of your product choices. It is as simple as saying that you buy what you trust. Thus, when we invest in a share, we buy what we trust.

It won’t be wrong to say that reputational risk lies in the sphere of trust, moral principles, and the thinking of the companies.

Conclusion:[14]

Balancing the needs and interests of different stakeholder groups is notoriously difficult. This should not however be used as an excuse for making no effort to achieve such a balance. Hill and Jones (1992) also pointed out that many of the concepts and languages of agency theory could be applied equally well to stakeholder-agency relationships. Although, the moral discourse for company management implied by agency theory and stakeholder theory is vastly different, As Quinn and Jones (1995) explained, adopting one perspective (that of agency) leads to a discourse based on self-interest, whereas adoption of the other leads to a discourse of ‘duty’ and social responsibility. Unless these perspectives can be merged in some way, the managerial discourse cannot be expected to combine fully the extremes of profit-seeking self-interest and moral responsibility to society. Therefore, the only realistic compromise solution to this problem is to adopt the business case, rather than the pure ethics case. Unless corporate social responsibility and accountability enhance shareholder wealth, neither company management nor large institutional investors, nor small-scale shareholders would ever endorse it as a realistic approach to corporate activity. It is more realistic to accept that ethics have to be profitable in order to be acceptable to businesses. It is only by taking account of stakeholder as well as shareholder interests that companies can achieve long-term profit maximization and, ultimately, shareholder wealth maximization.

Bibliography

1.   Corporate governance and accountability

J Solomon, 2007 – Wiley

 

  1. An Agent Morality View of Business Policy

Dennis P. Quinn and Thomas M. Jones

The Academy of Management Review, Vol. 20, No. 1 (Jan., 1995), pp. 22-42

  1. 3.   J.W. Lorsch, “Pawns or Potentates: The Reality of America’s Corporate Boards” (Boston: Harvard Business School Press, 1989), 7-8.

 

4.   A stakeholder theory of the modern corporation

RE Freeman – Perspectives In Business Ethics (special Indian Edition) – Mcgraw Hill

 

  1. Corporate Social Responsibility and Environmental Management Corp. Soc. Responsib. Environ. Mgmt. (in press) Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/csr.132

 

  1. Ellsworth, “Leading with Purpose,”

 

  1. J. Cassidy, “The Greed Cycle,” The New Yorker, Sept. 23, 2002, 64-77. Also see Cassidy for a thorough and accessible treatment of the factors driving the shift to a “shareholder value” perspective.

 

  1. R.A.G. Monks and N. Minow, “Corporate Governance” (Cambridge, Massachusetts: Blackwell, 1995), 38.

[1] Corporate governance and accountability

J Solomon, 2007 – Wiley

[2] An Agent Morality View of Business Policy

Dennis P. Quinn and Thomas M. Jones ; TheAcademyofManagementReview, 1995

[3] Sec. 1065. Nature and definition of private corporations. http://chestofbooks.com/business/law/Law-Of-Contracts-4-2/Sec-1065-Nature-And-Definition-Of-Private-Corporation.html

Last accessed on 20-11-2009.

[4] Corporate governance and accountability

J Solomon, 2007 – Wiley p. 23

[5] A stakeholder theory of the modern corporation

RE Freeman – Perspectives In Business Ethics (special Indian Edition) – Mcgraw Hill

[6] Corporate Social Responsibility and Environmental Management Corp. Soc. Responsib. Environ. Mgmt. (in press) Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/csr.132

[7] J. Cassidy, “The Greed Cycle,” The New Yorker, Sept. 23, 2002, 64-77. Also see Cassidy for a thorough and accessible treatment of the factors driving the shift to a “shareholder value” perspective.

[8] J.W. Lorsch, “Pawns or Potentates: The Reality of America’s Corporate Boards” (Boston: Harvard Business School Press, 1989), 7-8.

[9] Ellsworth, “Leading with Purpose,” 348.

[10] R.A.G. Monks and N. Minow, “Corporate Governance” (Cambridge, Massachusetts: Blackwell, 1995), 38.

[11] Ellsworth, “Leading with Purpose,” 349.

[12] TransAlta Chair, Donna Soble Kaufman, speaks to attendees of the Conference Board of Canada Spencer Stuart National Awards in Governance ceremony. This speech was given in Toronto on Feb. 10, 2009. < http://www.transalta.com/newsroom/speeches-presentations/2009-02-10/conference-board-canada-keynote-speech-spencer-stuart-nat>

Last accessed on: 19-11-2009

[13] Reputation is everything | BME| CPI Financial http://www.cpifinancial.net/v2/Magazine.aspx?v=1&aid=1365&cat=BME&in=92

Last accessed on: 20-11-2009

 

[14] Corporate governance and accountability

J Solomon, 2007 – Wiley

 

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