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Past Issue • Jan-Mar 2014

An Upheaval in Corporate Purpose

Safeguarding the interests of all stakeholders is the rousing call to arms of the new Companies Act, but will mere changes to the corporate governance codes achieve this objective? Nawshir Mirza fuels the debate on the new company law with some hard-hitting questions: How exactly are firms to balance the interests of all their stakeholders and achieve compliance, when no measure of value exists for certain stakeholder groups? Will new thinking bring about a radical shift in the purpose of the firm?

In his 1962 book, “Capitalism and Freedom,” University of Chicago professor and Nobel prize-winning economist, Milton Friedman, famously declared, “Few trends could so thoroughly undermine the foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible.” Friedman’s book went on to have a profound influence on businesses in America and many other countries that professed the capitalist creed. The belief that maximising shareholder value was the sole purpose of all corporate existence was given strong impetus with its endorsement by so eminent an economist.

Friedman, of course, exaggerated the importance of the traditional concept of the “purpose of the firm”: shareholders put up the capital for a firm and consequently the firm should subserve their interests alone. Others who interact with the firm to create social wealth – employees, suppliers, customers, the government and society – have a contractual or a statutorily defined relationship with it, and any expectations that they have ought to be captured in those agreements. Since shareholders contribute to the capital requirements of a firm and stand last in line to be paid when the firm is liquidated, it is in them that all power over the firm should be vested and it is for them that it should exist.

The Company in Historical Perspective

This view has its origins in the beginning of the 17th century, when British and Dutch sovereigns issued charters to several companies to trade in various parts of the world. The shareholders of these companies were empowered to elect at annual general meetings a committee (the board), which would choose one amongst themselves to be the governor (now called the Chief Executive Officer). The governor and the committee were charged with overseeing the management of the company. At the shareholder meetings, the shareholders had voting rights in proportion to the capital they had contributed. This basic structure of company governance and corporate democracy has remained unchanged for over 400 years and is the foundation of the governance of corporations in the capitalist system.

When those early companies were created, the industrial revolution was yet to begin. Agriculture, small-scale manufacture of goods and trade were the only commercial activities. Of the three factors of production – land, labour and capital, the first two were in surfeit whereas the last was in short supply. Wealth was measured in tangible assets and possessions; intangibles such as goodwill or business relationships had not even been conceived of. It was no wonder that the providers of capital were able to secure primacy in the charters issued by queens and kings. Governance was transactional – to receive power, a stakeholder had to contribute something (money) in return.

It is important to recall that political democracy in England at that time was also based on the principle that those who contributed to the king had the power to determine how he governed. Governance by the sovereign through the advice of a council was not a new idea. Athens had a similar political governance system, as did the Anglo-Saxons and the Normans. In 1215, the king of England lost both his divine right over the lives and liberty of his people and the absolute right to determine taxes when his barons forced him to sign the Magna Carta. Some years later, a parliament was established with three chambers – one each for the nobles, the church and the landowners. The church gave legitimacy to the king, the nobles provided him with soldiers to fight his wars and the landowners paid him land revenue (the only system of taxation then prevalent). All three gave something valuable to the king in return for the right to have a say in the country’s governance. But the members of parliament were nominated, not elected.

In this respect, political democracy lagged corporate governance, where the concept of elections was introduced in 1600. In 1689, the English Bill of Rights established elections to parliament for the first time, but only those who paid taxes were entitled to vote. The belief that the power to determine governance should vest in those who contributed to the exchequer remained strong. In 1701, a 100 years after the charter for the East India Company was issued, the Act of Settlement decreed that the king would select a cabinet, headed by a prime minister, to advise him and that the cabinet should have the confidence of parliament. The Act also introduced the concept of the oversight body’s independence from the executive: any person holding an office of profit under the government or in receipt of a government pension could not become a member of parliament. It took almost 300 years for this idea of independence to be inducted into corporate governance.

Even as political democracy was evolving in Europe, the French and American revolutions had a profound effect on the direction it would take. In both countries, the new revolutionary governments that came to power introduced universal adult franchise. (This right, however, was not extended to slaves or women till much later).

 

This stasis is the reason for all the stress that has developed in this field. The allegations that corporations have become too powerful, that they are causing climate change, that they overpay their senior employees and that they resort to deceit of every kind, are indications of this stress.

Importantly, the argument that only those who made some contribution to the nation had a right to determine how it was governed was discarded. The Jacobins in France and the founding fathers who drafted the United States Constitution concluded that the right to determine how a nation should be governed should belong to every citizen who is affected by that governance, regardless of his contribution to it. This gave a completely new perspective to political democracy, making elected governments responsible not merely to a privileged section of society but to all citizens. For the first time, the ruler was required to balance the interests of all his subjects; the privileged were no longer his only concern. However, none of these developments seeped into the laws that defined the governance of companies. At a conceptual level, corporate governance remains frozen in the same form it had in the charter granted to the East India Company in 1600.

This stasis is the reason for all the stress that has developed in this field. The allegations that corporations have become too powerful, that they are causing climate change, that they overpay their senior employees and that they resort to deceit of every kind, are indications of this stress. All recent developments have centred around the rituals of practising that antiquated creed, not the substance of it.

Many people wrongly believe that new corporate governance codes are causing fundamental change; they are not. The debate has been deflected onto the relatively smaller issue of minority shareholder rights, and has not concerned itself with the fundamental existential issue: for whom do firms exist?

Democratising Corporations?

Individual businesses have demonstrated commitment to some stakeholders. In the beginning of the 20th century, Jamshetji Tata and Lord Lever Hume, in setting up Tatanagar and Port Sunlight, respectively, showed that they cared for their workers’ welfare. The 1813 charter of the East India Company required its board to spend Rs 1,00,000 each year on promoting a scientific temper among Indians. But there was no holistic attempt to respect all stakeholders and balance conflicts of interest. While many academics in the past half century have accepted the need for balancing the interests of all stakeholders (by definition, those affected by the way any organisation is run), and most business leaders have paid lip service to it, there has been virtually no research on how such democratisation is to be achieved.

How are those who govern a firm, its board and its management to weigh competing and conflicting claims upon it from different stakeholders? How should the board be selected? Should only the votes of stakeholders who contribute equity count, or should the votes of other stakeholders be included?

How are those who govern a firm, its board and its management to weigh competing and conflicting claims upon it from different stakeholders? How should the board be selected? Should only the votes of stakeholders who contribute equity count, or should the votes of other stakeholders be included? Should any distinction be made among stakeholders who have a contractual relationship with the firm, those whose relationship is regulated by the law and those with whom neither obtains but who are, nonetheless, affected by the behaviour of the firm? Should there be a segmentation of power, depending on the matters to be decided by the firm’s management and board? How should the vote for candidates for directorship be taken – on a common slate or for each constituency separately? Once elected, do the directors have differing obligations to the firm, their respective constituencies and to other stakeholders?

Certainly, some progress has been made towards greater democracy in the corporation. Shortly before the Second World War, the New York Stock Exchange (NYSE) supported the formation of audit committees (Buchalter and Yokomoto, 2003). However, it was only in the 1970s that such committees began to gain currency. These committees were responsible for overseeing the financial reporting process and they achieved this by attempting (with varying degrees of success) to protect the auditor from any malign influence of the management. This, therefore, was the first small exception to the rule that the controlling shareholder in a firm ruled absolute.

In the 1990s, the idea of independent directors gained currency after the Cadbury Committee in the United Kingdom (UK) recommended their appointment. These directors are expected to act independently of the influence of both management and the controlling shareholder. They are expected to protect and advance the interests of their respective firms, as a whole, especially where these clash with those of the management or the controlling shareholder. The independent director concept was implemented in most jurisdictions, not by amendments to company law but because the capital markets required it.

For example, in India, it was introduced by the stock exchanges on the direction of the Securities and Exchange Board of India (SEBI). But the selection and appointment of independent directors continues to be made only by the shareholders at a general meeting, ergo, the controlling shareholder of a firm still determines who sits on his company’s board. In order to compensate for this fundamental defect in the institution of independent directors, various governance rituals and devices have been invented, such as having independent directors in a majority on important committees, holding private meetings of such directors, etc. However, the fact that their position is dependent on the imprimatur of the controlling shareholder leaves a gaping breach in the system.

When the institution of independent directors was constituted, one of the requirements imposed was that they should not be stakeholders of any sort in the business. This was in order to put them beyond the risk of management coercion. Unwittingly, this made them equi-distant from all stakeholders, and hence, in the best position to be fair to them all. Many corporate commentators began to suggest that this responsibility (of fairness to all stakeholders) be added to their role, overlooking the reality that they were struggling to discharge even the much lighter responsibility of championing the firm’s rights when they were in conflict with related parties.

Even as these embryonic ideas were being discussed, the Government of India passed into law, a few months ago, a new Companies Act in which boards in general and independent directors in particular are mandated with safeguarding the interests of all the stakeholders of a firm. Safeguarding diverse rights requires a balance to be struck between conflicting claims. As an exhortation to good corporate conduct, this is a stirring slogan, but as law, it has created immense challenges for firm managements and their boards.

While corporate social responsibility might encompass the balancing of stakeholder rights, it is not the same thing. The balancing of interests requires that the aggregate gain to one or more stakeholders should at the very least be greater than the aggregate loss to the others. This presupposes that it is possible to measure the various interests on a uniform scale, obviously in monetary terms.

The selection and appointment of independent directors continues to be made only by the shareholders at a general meeting, ergo, the controlling shareholder of a firm still determines who sits on his company’s board. In order to compensate for this fundamental defect in the institution of independent directors, various governance rituals and devices have been invented, such as having independent directors in a majority on important committees, holding private meetings of such directors, etc.

Can Stakeholder Value Be Measured?

Over the decades, various measures have evolved for measuring shareholder value – profit, cash flow, economic value added, net worth, internal rates of return, discounted values of future cash flows, pay back periods, etc. In spite of years of use and improvement, none of these are perfect, being highly influenced by the opinions of their users. Some measures of the value of the relationships other stakeholders have with the business have been developed; the customer satisfaction index and the employee engagement score are examples. But these are not rupee measures, and it would, in any case, require a multi-pan weighing scale (visualise a merry- go-round with a seat each for about eight riders) to balance the interests of various stakeholders.

For several stakeholders, no measure even exists. How is value to be measured for the business relationship with the immediate community and with the more distant communities? Human resources (HR) science has developed a few models for valuing, in monetary terms, the human resources of entities, but the models are too primitive to be of use in meeting a legal obligation.

Consider the following situations:

  1. A company is laying a railway to link a newly acquired coal mine to its power station. It can lay a direct route, which bisects a wildlife migration corridor, or it can go around the jungle, adding to the cost of the power to be generated. In the former case, the power would be among the cheapest available in the market (in the bottom quartile), whereas in the latter option, it would be slightly above the median cost.
  2. A property development company is bidding for land along the strand in a large city. At the prevailing prices, the project would only be profitable if 25-storey towers are constructed. These buildings would block the sea breeze that a large part of the town enjoys and kill or injure migratory birds that collide against their glass facades. If the company did not bid, there would be other competitors who would gladly execute the project.
  3. A manufacturer of heavy machinery sources many of its components from small manufacturers. Many of these vendors were developed with assistance from the manufacturer and depend on it for almost all of their business. The manufacturer is very profitable. Should it subject them to cut-throat competition pricing (new vendors have entered the market), or should it agree to a price that allows them also to share in some of the overall success? What percentage, from zero to 100, should this be?
  4. In open bidding, a power company has agreed to supply power to a city at a fixed price for 25 years. The unexpected rise in the cost of fuel has made this agreement onerous and it could threaten the company’s survival. Should the company renege on the agreement, banking on the hope that the country’s notoriously slow legal system will delay a conclusion for about 15 years?

Let us examine the first example. The beneficiaries of laying the railway track through the jungle would be the consumers of power across the country, the company’s employees, its shareholders and its lenders. On the other hand, the losers would include wildlife (whose survival would be endangered), local tribes dependent on forest produce, people living nearby who would lose a source of clean air, the loss of natural beauty to current and future generations who might visit this jungle, and the drying up of aquifers beneath the jungle, leading to water shortages to farms and towns downstream. How would the management be able to put a value to each of these gains and losses?

Neither the social sciences nor management science has advanced to a stage where company managements and boards could use their work to answer that question. The issue is not hypothetical; there are many non-governmental organisations (NGOs) that will gladly use this amendment in company law to pressure companies to respect the stakeholders they represent. Can the natural world, animals and plants, be declared stakeholders for this purpose? Some groups might even misuse the provisions to stall projects or to extort compensation. Competitors could use these provisions to hurt their rivals. What then should boards do in the future? It is not inconceivable that these matters could end up in courtrooms. Managements would be required to establish that they considered all stakeholder interests before making their decisions, especially those of a strategic nature or those having widespread effects. Given the rudimentary nature of this science, they would perhaps need to take the following steps:

  1. Secure board approval of a list of all stakeholders who are, or could be, affected by the company’s operations, given its current strategy.
  2. Establish, with assistance from external experts where needed, what is the current impact and what may be the future effect of its operations on each of those stakeholders. This would need to be in narrative form unless quantification is possible.
  3. Establish protocols, with board approval, to determine at what level the effect on any stakeholder is significant enough to require its consideration in future decisions.
  4. State the impact on stakeholders who might be significantly affected in all proposals either to the board or to senior management. Such statements would be quantified to the extent feasible.
  5. State that all stakeholder effects have been considered in board resolutions or approvals of decisions.
  6. Managements and boards would need to completely change the culture and attitude of the organisation towards such matters as impact on the environment or on vendors. Google’s motto of “Do no evil” may be a good start.

Business schools and professional bodies would need to incorporate this new requirement into their curricula. Lawyers would need to study any precedent, in India or elsewhere, that would help the courts in determining cases brought under this provision and guide managements in the correct course of compliance.

Having taken this step before a proper body of knowledge is available to assist it, India could very well be headed for great chaos, or it may set the trend for a long overdue, tectonic change in the purpose of the firm. This new purpose will strike at the very roots of the capitalist system, which has made growth the only measure of success and consumerism the tool of its achievement. It might, once the tremors subside, lead to a new age of stability and universal happiness. Or, it could be only the first of many major upheavals that will topple commercial society and cause massive destruction.

FURTHER READING

Milton Friedman (1962). Capitalism and Freedom (Chicago: University of Chicago Press).

Buchalter, SD and KL Yokomoto (2003). “Audit Committees’ Responsibilities and Liability”, CPA Journal, March 2003.

ABOUT THE AUTHORS

  • Nawashir-Mirza

    Nawshir Mirza

    Fellow of the Institute of Chartered Accountants of India, Independent director on the boards of several companies and a thinker on corporate governance issues.
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