Shareholder primacy

By Ingrid Goodspeed

Introduction

Since the 2007/2008 global financial crisis and its aftermath, the doctrine of shareholder primacy has come under increasing scrutiny, even criticism. Shareholder primacy embraces a shareholder-centric view of corporate governance that emphasises the maximising of shareholder value while only derivatively considering the interests of other stakeholders such as society, the local community, consumers and employees.

The debate of course is not new and dates back to the 1930s when the Harvard Law Review published a discussion on the topic by two leading corporate scholars. Berle argued for shareholder primacy i.e., that corporations exist for shareholder wealth maximisation. On the other hand Dodd emphasised the “stakeholder approach” and argued that the proper purpose of the corporation also included more secure jobs for employees, better quality and value-for-money products for consumers and greater contributions to the welfare of the community.

Until the 1980s company directors generally crafted and oversaw implementation of corporate strategy with little reference to shareholders and limited discussion about their accountability. Since then, partly in response to spectacular corporate failures such as Polly Peck, BCCI and Maxwell, the practice of corporate governance shifted towards one of shareholder value maximisation.

Corporate law generally links the interests of the corporation to those of the shareholders. Although it does not refer to shareholders as owners, it does recognise that they have proprietary interests in the corporation. These are generally codified in the form of control rights such to vote on the election and removal of directors and to receive certain information about the company’s activities and inspect the company’s books and records. In some jurisdictions shareholders also have a say-on-pay. Further corporate law has generally codified directors’ fiduciary duties as the promotion of the success of the corporation for the benefit of shareholders – the most common formulation used by the courts is that directors owe their fiduciary duties to “the corporation and its shareholders”. In practice the severity of the shareholder primacy rule has been curtailed through other corporate law principles. For example, the business judgment rule has played an important role in expanding director discretion to take into account the interests of other stakeholders.

Do shareholders own corporations?

Key to the debate around shareholder primacy is the question of ownership of a corporation and whether in fact the corporation is a thing capable of being owned. The traditional generally-accepted view is that a company is owned by its shareholders and that they exercise ultimate control of the company. Consequently directors and executives should maximise shareholder value usually measured by the share price. In this case the balance of rights will tip more heavily in the favour of shareholders, and against other stakeholders such as bondholders, creditors, employees and the community.

Another, maybe similar argument is that shareholders provide risk capital and as such require control rights to protect their investment. This argument is appealing, especially in the financial sector where shareholders of reference may be called upon by regulators to provide additional capital when a bank is in trouble. Then again some stakeholders such as employees, the community and society may take even greater risks if the company destroys jobs and the environment in the course of shareholder wealth maximisation.

Today there is agreement among legal scholars and academics that shareholders do not in fact own the company. Instead the company is considered a legal entity that owns itself. What shareholders own are shares in the company. As such the corporation is a nexus of contracts among various stakeholders and shareholders have no special role in the corporation and their rights, like other stakeholders, are limited to those provided by contract.

Shareholders versus investors

Another argument against shareholder ownership of corporations is the view that in general shareholders do not think of themselves as partial owners of a corporation. Instead they see themselves as investors: capital market participants who view companies as investment prospects, analyse company-specific information, and make buying and selling (i.e., trading) decisions about companies’ equity (and debt) securities based on such information. Holders of equity investment contracts are free to buy or sell the shares of the company without loyalty.

Aron and Muellbauer (2006) estimated that at the end of 1969 individual shareholders held 41 per cent of the market capitalisation of the JSE and 18 per cent at the end of 1997. By 2012 this percentage had fallen to 9 per cent. Thus a substantial majority of the market capitalisation in South Africa (and the rest of the world) is held by institutional investors – pension funds, insurance companies, asset managers and collective investment schemes. The search for short-term gains by institutional investors is often cited as one of the reasons for the excessive focus of corporations on short-term earnings at the expense of long-term sustainable growth and value creation. For this reason internationally accepted principles (2011 and 2012 update of the UK Stewardship Code, 2011 Code for responsible investing in South Africa) prescribe that institutional investors take a stewardship responsibility toward investee companies to the extent that this aligns with their primary fiduciary obligation to enhance value for beneficiaries. However given they hold shares in hundreds of companies it would be surprising if they could focus on the governance of more than a few companies.

In support of shareholder primacy

In the last two decades of the 20^th century and early in the 21^st century spectacular corporate and governance failures together with a hostile debt-led takeover boom, corporate tax evasion and excessive executive pay and bonuses led to heightened concern about managers calling almost all the shots and the apparent ineffectiveness of company boards to challenge poor management and governance practices. This led to demands for the increased accountability of boards to shareholders and the predominant view became that the overriding purpose of corporations should be the pursuit of shareholder value.

One of the strongest arguments in favour of shareholder primacy is that it provides coherent and compelling guidance for directors to follow. Directors have a clear measuring stick to base their decisions on namely maximising the wealth of the corporation’s shareholder with the share price as the best proxy for corporate performance. In addition, shareholder wealth maximization provides a strong mechanism for monitoring the behaviour of directors as it clearly indicates decisions that breach the fiduciary duty and those that do not. A single corporate objective like profit maximisation is more easily monitored than many imprecisely defined goals such as the fair treatment of all stakeholders.

Against shareholder primacy

Key problems attributed to shareholder primacy and the exclusive pursuit of shareholder value include:

• Short-termism in corporate thinking and decision making encouraged by short-term incentives or performance pay for executives and directors based on the maximisation of profits
• Corporate profits spent on dividends and share buy-backs rather than on innovation, productive capabilities and research and development. Dividends are the traditional, and legitimate, way for corporations to provide income to shareholders. However there is strong empirical evidence of high and sticky dividend payout ratios, almost irrespective of profits. The argument against share buybacks is that they increase share prices in the short-term, which merely serves the interests of executives, managers and directors whose compensation is in the form of shares.
• Not investing corporate profitability in innovation has the potential to reduce national economic growth and prosperity.
• Underestimating the risk exposure of stakeholders. If a corporation fails employees stand to lose livelihoods and pensions and local communities may suffer lower economic growth and higher unemployment. In addition the search for shareholder value to the exclusion of all else may lead to the contamination of natural resources and the sacrifice of viable farmlands to corporate development. Further a country’s tax revenues are reduced as companies seek to minimise tax payments to maximise value for shareholders through activities such as profit shifting and transfer mispricing.
• Debt-laden and value extracting or destroying takeovers or leveraged buy-outs.

Way forward

A number of suggestions have been put forward to implement a stakeholder approach to corporate governance that negates the detrimental effect of shareholder primacy and considers the interests of all stakeholders. These include:

• Reforming codes of corporate governance and stewardship to encourage boards to promote the long term success of companies so that all stakeholders as well as the economy as a whole flourish. Interestingly the draft King IV code of corporate governance stresses the balancing of the needs interest and expectations of all stakeholders by the board and suggests the board is accountable to all material stakeholders not only primarily shareholders.
• Reforming legislation to recognise the social and environmental imperatives required of corporations in addition to their economic performance. Protection for companies from hostile and value-extracting and destroying takeovers.
• Revising directors’ legal duties to promote the longer-term success of the corporation.
• Improving the diversity of board members, which could include a greater proportion of women on boards as well as investor representatives.
• Giving employees a right, perhaps a statutory one, to representation on the board.
• Ending the requirement in many jurisdictions for quarterly reporting.
• Changing capital gains tax to encourage long-term shareholding.

Why is the debate around shareholder primacy so important? To quote Andrew Haldane chief economist of the Bank of England: “Challenges to the shareholder-centric company model are rising, both from within and outside the corporate sector. These criticisms have deep micro-economic roots and thick macro-economic branches. Some incremental change is occurring to trim these branches. But it may be time for a more fundamental re-rooting of company law if we are to tackle these problems at source. The stakes – for companies, the economy and wider society – could scarcely be higher.”

Bibliography

Aron, J and Muellbauer, J. 2006. Estimates of Household Sector Wealth for South Africa, 1970 – 2003. Review of Income and Wealth, Vol. 52, No. 2: 285 – 308. International Association for Research in Income and Wealth.

Governance Institute of Australia. 2014. Shareholder primacy: is there a need for change? Accessed March 2016. http://www.governanceinstitute.com.au/advocacy-research/thought-leadership/shareholder-primacy-is-there-a-need-for-change/

Haldane, Andrew. 2015. Who owns a company? Bank of England. Accessed March 2016. http://www.bankofengland.co.uk/publications/Pages/speeches/2015/833.aspx

Institute of Directors. 2016. Draft King IV report on corporate governance. Accessed March 2016. https://c.ymcdn.com/sites/iodsa.site-ym.com/resource/resmgr/King_IV/King_IV_Report_draft.pdf

JSE. 2012. JSE Releases Third Study on Black Ownership on the Exchange. Accessed March 2016. www.jse.co.za

Stout, Lynn A. 2013. The shareholder value myth in the European Financial Review. Accessed May 2016. http://www.europeanfinancialreview.com/?p=883

Williamson Janet, Driver Claran and Kenway Peter. 2013. Beyond shareholder value. Accessed March 2016. https://www.tuc.org.uk/sites/default/files/BSV.pdf