Remember the day that the Bear O’Shea
Fell into a concrete stairs,
What the Horseface said when he saw him dead
It wasn’t what the rich call prayers.
I’m a navvy short, was the one retort
That reached unto my ears.
When the going is rough you must be tough
With McAlpine’s fusiliers.
‘McAlpine’s Fusiliers’ by Dominic Behan
It is almost impossible to pick up a management journal today without seeing reference to ‘purpose’. Every company is being urged by every academic to get a purpose; without one they haven’t got a life.
What is purpose? Purpose is the reason for a company’s existence. It answers the question, why does a company exist? One obvious answer is to make profits. But that is no more of an answer than happiness is an answer to the question of what is the purpose of life. Of course we would rather be rich than poor and happy rather than miserable. But those are not the reasons why companies or we exist.
The reason why companies exist is to do things, and their purpose is a statement of that. In exact contradiction to the Friedman doctrine, what people have in mind when they refer to the purpose of a company is not just to produce profits. The purpose of companies is to produce solutions to problems of people and planet and in the process to produce profits, but profits are not per se the purpose of companies. They are derivative from purpose rather than fundamental in their own right.
One way of determining a company’s purpose is to answer the question what is its value proposition? What value is it seeking to create for whom over what period of time? Is it predominantly looking to enhance or maximize shareholder value, or consumer value, or the human capital of its employees, the social capital of its communities and societies, or the natural capital it owns and in its supply chain? Is it seeking to do this in the short or long run and in what ways will it enhance these values? These questions link together purpose with the values discussed in Chapter 2 and measures of performance in the next chapter (Chapter 6), and by answering them they establish a corporation as a self-reflexive entity. The parties involved in addressing and answering them are the source of the corporate consciousness, and the means by which it commits to them are the basis of its corporate integrity.
There are two conceptualizations of corporate purpose—a positive and a normative. The positive is literally a statement of what the company is there to do—to produce cheap consumer goods, reliable cars, or the largest social networks. The normative is a statement of what the company should do—to look after its employees, to clean up the environment, to enhance the well-being of its communities and societies within which it operates. The latter has a social public-service element that goes beyond the private interests of the company’s consumers or investors. The distinction is between ‘making a good’—the positive—and ‘doing good’—the normative.
One reason why the distinction is important is that it is reflected in company law. Here is Section 172 of the 2006 UK Companies Act: ‘A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.’ The members of the company are essentially its shareholders, so what this is saying is that the director of a company has a fiduciary responsibility to promote the success of a company for the benefit of its shareholders.
The section of the Act then goes on to say that the director must:
in doing so have regard (amongst other matters) to: (a) the likely consequences of any decision in the long term, (b) the interests of the company’s employees, (c) the need to foster the company’s business relationships with suppliers, customers and others, (d) the impact of the company’s operations on the community and the environment, (e) the desirability of the company maintaining a reputation for high standards of business conduct, and (f) the need to act fairly as between members of the company.
So in promoting the success of the company for the benefit of its shareholders, the directors of the company should have regard to the interests of other stakeholders. However, these are derivative of the requirement to promote the interests of the shareholders and are not a primary duty in their own regard.
Shareholder primacy is present in other jurisdictions. For example, Leo Strine, Chief Justice of the Delaware Supreme Court, is unequivocal about the relevance of shareholder primacy in US legislation: ‘Stockholders are the only corporate constituency with power under our prevailing system of corporate governance.’1 Whether the duty of the directors is to shareholders or stakeholders, or, as the section of the UK Companies Act goes on to say, under certain circumstances, to the company’s creditors, the focus is not first and foremost on the company’s purpose. The ordering goes from shareholder and possibly other stakeholder interests not from purpose to the company’s activities.
Does this matter? To some degree it does because if directors had a fiduciary responsibility to uphold a corporate purpose then they could be held to account for its delivery. In particular, if the purpose had a normative component of doing good as well as making a good, then directors would in principle be obliged to promote a social as well as a private benefit.
There are three reasons why in practice this might not be quite as significant as it initially looks. The first is that in a private corporation it is up to the members of the corporation, its shareholders, to seek a remedy for a violation of a breach of fiduciary responsibility. The imposition of the public purpose is therefore dependent on the shareholders’ willingness to do so. If sufficiently publicly spirited, then shareholders might act in this way, but if they are as self-interested in their financial earnings alone as they are often depicted as being then they will not. So the enforcement of a purpose that does any more than promote the financial benefits of shareholders may remain weak, even if purpose was made more prominent in company law than it is at present.
Secondly, shareholders do not in general sue their directors, at least outside of the United States. It is for the most part regarded as a complex, expensive, and largely self-defeating exercise if, at the end of the day, any recompense for breach of duty comes from the company itself. But the most important reason why the law is not decisive on this matter is that there is a still more pragmatic influence on corporate practice—the market for corporate control. Directors fear the wrath of shareholders through their direct engagement much more than through the courts. It is the telephone call from an activist shareholder backed up by the possibility of a resolution at a shareholder meeting that threatens the survival of corporate directors, and it is this that bears the greatest influence on their behaviour.
Strine provides a graphic illustration of the consequences of shareholder interventions for one of the United States’s most prominent corporations, DuPont, its hometown of Wilmington, Delaware, and its industry rival and fellow victim of insurgent investors, Dow Chemical Company, with which it subsequently merged:
When it came down to it, the DuPont board knew who called the shots and surrendered the direction of the company to the prevailing market winds…And, therefore, it was without any apology or shame that DuPont and Dow not only presented their historic home communities with gut-wrenching job losses, facility closures that threatened to hollow out towns, and all the damage to other businesses that came with those decisions, but then asked those home communities to go into the pockets of ordinary taxpayers.2
Jack Coffee emphasizes the impact of hedge-fund activism on board conduct in the context of the case of Valeant Pharmaceuticals, which according to Coffee, the press described as a ‘hedge-fund hotel’.3 It allegedly employed high-powered executive incentive schemes to encourage management to slash costs, shrink research and development, and raise pharmaceutical prices. More generally, Coffee suggests that the rise of what are termed ‘wolf packs’—groups of activist shareholders working together to gain control of a corporate board—has resulted in the appointment of ‘blockholder directors’—directors selected by the insurgent investors. As a consequence, Coffee documents the transition of corporate governance in the United States from managerial corporatism between 1920 and 1985, through the passive shareholder capitalism that prevailed between 1985 and 2005, to the current system of hedge-fund activism.
As Strine says: ‘These powers translate into purpose because those who run corporations owe their continued employment as managers and directors to the only constituency the corporate law establishes—stockholders.’4 So even if the law required the company to have a clearly defined purpose and directors to uphold that purpose as their fiduciary duty, then it would only be a primary determinant of their behaviour if potential activist shareholders had an interest in societal benefits beyond their own. Otherwise, it will be business as usual with directors focused on what activists regard as the source of shareholder value.
Tacking purpose onto a system that remains institutionally wedded to shareholder value will not turn the tide of corporate activity in the direction in which purpose wishes to point it. We need to get closer to the core of the issue, and the core is the governance of the corporate purpose.
There is a widely held view that corporate governance is about enhancing shareholder value, protecting shareholder interests, and ensuring that firms act in the interest of their shareholders. Here, for example, is what the UK Corporate Governance Code, which is widely regarded as an authoritative statement of best practice, says:
While in law the company is primarily accountable to its shareholders, and the relationship between the company and its shareholders is also the main focus of the Code, companies are encouraged to recognise the contribution made by other providers of capital and to confirm the board’s interest in listening to the views of such providers insofar as these are relevant to the company’s overall approach to governance.5
It therefore exactly parallels the UK Companies Act quoted above in paying due respect to stakeholders at large while clearly recognizing the primacy of shareholder interests. The Corporate Governance Code is designed to promote the success of a company in the interests of its shareholders.
This view of corporate governance is mirrored in policy advice that has repeatedly been given by both UK and US governments in regard to the way in which corporations should be governed around the world. In the East Asian crisis of the second half of the 1990s, observations were made by the IMF and the then chairman of the US Federal Reserve, Alan Greenspan, about the impact of crony capitalism and the need for East Asian countries to dismantle their traditional corporate relationships and adopt US-style dispersed ownership systems.6
This advice did not look quite so compelling four years later when the dotcom bubble burst at the beginning of the millennium. At that point, the response was to argue for a strengthening of corporate governance standards to ensure that there was greater accountability and better information provided in corporate accounts. But it was precisely the countries that adopted these standards, namely the United Kingdom and the United States, that suffered the most during the financial crisis five years later and those companies with the supposedly ‘best corporate governance arrangements’ that performed the worst during the crisis. The greatest degree of risk-taking occurred where companies aligned their managerial incentives most closely with shareholder interests, and those companies with the ‘best systems of corporate governance’ in the traditional sense, for example of having independent board directors, had the worst record of failures during the crisis.7
The reason that policy prescriptions repeatedly failed is that corporate governance is not and should not be about enhancing shareholder value. It is about promoting corporate purpose and the two are not the same. The governance of a firm in all its guises should define how a company assures the delivery of its purpose: the structure of company boards (independent directors and the appointment, induction, and servicing of new board members); the conduct of boards in terms of audit and risk management committees; the determinants of executive compensation, remuneration committees, and shareholder voice over executive compensation; and relationships between investors and firms in regard to information, transparency, shareholder activism, and shareholder engagement in corporate activities. It is directly related to the policies being promoted at national and international levels in regard to the development of better legal systems and contractual rights, stronger investor protection, more say on pay, rights of shareholders to propose shareholder resolutions, and creditor rights.
The correct focus of corporate governance should not therefore be on enhancing shareholder value per se, but on how these aspects of corporate governance in terms of ownership, boards, and remuneration promote corporate purpose and flourishing companies. By recognizing a company’s customers as comprising all of its consumers, communities, and citizens, corporate governance achieves corporate flourishing and profitability by furthering the collective well-being of its consumers, employees, suppliers, and societies. In the process it enhances economic growth, entrepreneurship, innovation, and value creation and may thereby lead to increased shareholder value, but corporate governance is not about shareholder value. In an exact inversion of the traditional ranking, purpose is primary and shareholder value derivative.
One implication of this is for diversity. Since countries, industries, and companies have multiple and different purposes, what is suited to one country, industry, or firm is not to another. To appreciate this one only has to recall the history of corporate governance standard bearers. In the 1980s, Japan was regarded as the model of good corporate governance until Japanese banks collapsed in the 1990s. In the 1990s, it was the turn of the United States with its technology-friendly governance standards, until the tech dotcom bubble burst in the early 2000s. Then it was the turn of the UK model with its greater emphasis on general governance principles such as ‘comply or explain’ than inflexible rules, until the financial crisis put an end to that.
Now it might be Sweden or another Scandinavian country that is the standard bearer, in which case one can predict with confidence that it will not remain so for long. The reason is that there is no one best system of corporate governance that is suited to all companies at all times. The United Kingdom is a good illustration of this. It established corporate governance codes that promoted independent directors, auditors, and remuneration committees well before many other countries. It has a dispersed share-ownership system, the most active market for corporate control of any country in the world, increasing institutional activism, and some of the strongest creditor rights anywhere, and yet its performance in terms of growth, innovation, investment, and productivity has been poor over a long period of time.
Since companies have such diverse corporate purposes, there are significant risks of formulating prescriptive corporate governance codes. There is a problem of identification of appropriate forms of governance, as exemplified by the focus on dispersed ownership after the Asian crisis twenty years ago. There are unintended consequences, as illustrated by the relationship between independent directors and banking activities before the crisis. There is excessive uniformity in corporate structures and practices that exacerbate rather than mitigate risks of failures spreading across countries and companies.
We need diversity rather than uniformity in corporate governance, and we need it in all its various manifestations—ownership, board structure, and incentives—to be focused on promoting the full breadth of corporate purposes and not the single goal of shareholder value. It is the basis on which the purpose and values are instilled throughout the organization, and without it management cannot deliver on purpose.
Being a responsible businessman is not straightforward. Money and morals are not natural bedfellows. It is easy to say that one does well (i.e. make profits) by doing good (i.e. being socially responsible), but the truth of the matter is that one often does a lot better by doing bad. The very act of persuading customers that one’s product is the best is a lie for every producer bar one, and only succeeds because it is in general extremely difficult to demonstrate otherwise.
In their book Phishing for Phools,8 George Akerlof and Robert Shiller provide a compelling demonstration that the problem is even more pernicious than that. Markets have no morals, be they product markets or markets for corporate control. Economic and commercial conduct succeeds by deceit and manipulation, and the invisible hand of markets, whose almost mystical virtues are so widely extolled, is in fact a seedbed of impropriety. Combine that with the fact that the masters of managers are the self-interested, short-term institutional investors, and the life of the enlightened chief executive officer (CEO) is not an enriching one—at least not as enriching as it would be were they less enlightened.
That is not to say that enlightened CEOs do not exist; it is just that it is hard to name many of them. Indeed, if one asks most people for examples, beyond Paul Polman, the CEO of Unilever at the time of writing this book, few others are forthcoming. Paul Polman’s case is illustrative of the problems. He was brave enough to make clear to his institutional investors from the outset how he intended to run Unilever and what he expected of them as well as what they should expect of him. Not many CEOs are willing to do that immediately on appointment, and the aborted acquisition of Unilever by Kraft at the beginning of 2017 is a reminder of how even those companies most committed to purpose are exposed to the vagaries of the market.
While important, corporate success is not just about visionary leadership; it is predominantly a matter of innovative management. There is mounting evidence that there are three aspects of management that are associated with doing well by doing good—purpose, practice, and performance. You have to want to do it, you have to bring others along in doing it, and you have to demonstrate you have done it.
An example of a company that embeds responsibility in the core of its business, not as philanthropy, is the John Lewis Partnership (JLP) in the United Kingdom. Storey and Salaman observe that:
The JLP managers place much emphasis on the importance of trust. Trust is the expected response to the successful demonstration that responsibilities are real and are honoured. Managers stress that customers trust the JLP and that is crucial for the success of the business. Customer trust is based on their trust in JLP partners and their confidence that the JLP employment model and values and ownership structure do not prioritize profit above partner or supplier welfare. In other words the JLP’s commitment to multiple responsibilities is important in affecting perceptions of the public and the performance of the business and therefore must be maintained.9
Many companies do not realize the extent to which doing good can be highly profitable as well as socially beneficial. Storey and Salaman quote one group manager at the JLP:
When Charlie Mayfield became chairman he expressed the Partnership’s strategy in these three terms: Partners, Customer Service and Profit. I think what he’s now trying to say is, he doesn’t want people to think about them as separate. They are completely interlinked.10
There are profitable opportunities around the world in terms of alleviating poverty, inequality, unemployment, and environmental degradation. The bottom and the middle of the pyramid may not individually have much spending power, but there are, unfortunately, a lot of them, and collectively they can account for a substantial source of revenue, if only one can find a way of reaching them. Similarly, future generations may have little current purchasing power but they are destined to be a lot richer than us and willing to pay for the environment and natural capital if we can protect and preserve it for them. In other words, there are substantial private benefits to be derived from the externalities of poverty and environmental degradation through their commercial internalization. This is not corporate social responsibility (CSR) as meritorious philanthropy; it is poverty alleviation and environmental protection as core corporate activities.
Of course, governments can do a great deal to assist with this through creating markets and subsidizing the production of these public goods, but there is much that the corporate sector can do itself, individually and collectively, through relationship and ecosystem building. The way in which companies such as Mars and Unilever have gained access to markets in the slums of the poorest cities and the products of farmers in rural communities in developing countries is by building ecosystems and partnering with organizations such as non-governmental organizations (NGOs), other companies, universities, and local and municipal governments.
The case of Mars operating in the slums of Nairobi through its subsidiary Wrigley illustrates how this works in practice.11 The programme known as Maua (Swahili for ‘flower’) has expanded the distribution of Wrigley’s products into informal settlements and rural areas through employers providing economic opportunities to subsistence sellers or micro-entrepreneurs, called ‘uplifters’. The programme taps into uplifters’ entrepreneurial abilities and connects them to a successful, established corporation and its products. This route-to-market project solves a key ‘last mile’ challenge for Wrigley and has opened up access to bottom of the pyramid markets in Nairobi. For micro-entrepreneurs, the programme has served as a platform for broader social benefits, including participant-led coordination and group formation, and training and information sessions.
The programme has grown quickly, and Maua now forms a key part of Wrigley’s distribution system. In 2014 the programme reported double-digit growth. By 2015 the programme engaged with approximately 450 individuals and generated over $4.5million—15 per cent of Wrigley’s national business and a level of earnings significantly exceeding that of the conventional parallel route to market models.
There are four key components to such programmes. The first is identifying the human, social, or environmental issues that need to be solved—what are termed the ‘pain points’ in the ecosystem in which the company is operating—in its supply chain, within its own operations, or, as in this case, in its distribution network. Second, the company needs to gain a deep understanding of the issue at hand and the challenges that confront participants in the ecosystem. It is very easy to presume that one knows the right answers but it is very difficult to get them right in practice. To do this, companies have to spend time consulting with local and international experts, with people in the field, with relevant local and national organizations and government agencies.
Third, the company has to establish close and enduring relations with relevant organizations and individuals in what are termed ‘hybrid value chains’. It will have neither the skill set nor the contacts to do this itself, and relationship building is critical to the partnerships that firms need to support them in often unfamiliar and difficult terrains.
The Maua case illustrates all three of these elements. First, Mars Wrigley identified the pain points in its distribution systems in Nairobi and the failure of its existing arrangements. Second, it invested a great deal of time and effort in exploring the issues confronting people living and working in the slums of Nairobi. And third, it established relations with a number of NGOs such as Technoserve, which focuses on creating economic opportunities for women.
There is a final element that presents particularly significant challenges. Even if one is determined to do well by doing good and establishes the ecosystem that is required to achieve it, then there is still a powerful agent acting against it—performance. We know how to measure profits, at least we think we do, but we do not know how to measure much else. In particular, it is much harder to measure such nebulous concepts as human well-being, social capital, and natural capital, or at least to attach monetary values to them with the same precision as profit.
There are measures of human, social, and natural capital, but in general they rely on non-market as well as market prices derived from such tenuous sources as surveys of people’s preferences and projections of benefits into the distant future that have to be discounted at subjective rates back to the present. As a consequence, even if a company creates good, it is much harder for it to demonstrate that it is the source of it doing well and to incentivize people to produce the good that is serving them well.
In the case of Maua, Mars Wrigley devoted a considerable amount of effort to creating measures of human and social capital associated with the programme. They worked with partners in academic institutions in identifying the state of the art for measuring these non-financial forms of capital and engaged in regular measurement of performance of the programme on these multiple dimensions as well as financial returns. The importance attached to providing precise measures of performance was a distinctive feature of the programme and was rewarded in, firstly, it focusing on those aspects that were critical to its success and, secondly, in demonstrating the nature of the relation between human and social capital with financial capital.
However, the greatest problems of all in doing well by doing good are not those outside the corporation on the ground or in the field but inside the corporation itself. It requires vision and leadership for the company to recognize the potential benefits to the firm as well as its stakeholders from adopting such practices. And even if the board of directors are fully supportive then the greatest opposition comes below from middle management that are unfamiliar with the processes required to promote people and planet as well as profits. They see them as contrary to their own interests in achieving the financial goals that are expected of them and as ‘soft’ approaches to tackling the tough realities they face on a daily basis in competing for business and custom.
In other words, doing well by doing good is a management innovation that is at least as challenging as a technological innovation. It requires the same determination and commitment from those at the top of the organization and it involves the same cultural conflicts lower down between those who are undertaking the research and development (R&D) required to identify the new markets, methods, and measurements and those for whom it is business as usual. As a result, they need the same ‘safe places’ within which to undertake the managerial experimentation as the science labs of the R&D departments. That is precisely what companies like Mars and Unilever create, and that is why Maua provides exactly one such space in the form of a pilot in Nairobi in which the think tank Mars Catalyst was able to develop the concept of the Economics of Mutuality that underpins Mars’ approach to doing well by doing good in Maua.
Doing well by doing good is a form of business innovation as significant as the technical innovations that are recognized as the source of commercial opportunities. The successful organizations of the future will be those that are able to exploit the remarkable human, social, and environmental as well as technological opportunities of today. But even if the leadership recognizes this and can overcome the resistance of middle management, create the safe spaces for experimentation, identify the pain points in the ecosystem, form the partnerships, and measure the various types of capital, there still remains one overwhelming hurdle to doing well by doing good and that comes from those who ultimately pull the strings.
Chapter 4 documented the dominance of families as owners of some of the largest companies listed on stock markets around the world. However, even they pale into insignificance in relation to the largest owners of financial capital—the institutional investors. There is currently over $70 trillion in assets under management by institutional investors. The largest three—Blackrock, Vanguard, and UBS—together command around $10 trillion. It is to these giants of asset management that we need to turn for the successful transformation of short-term safe liquid savings of individuals into long-term risky illiquid assets of companies.
A number of institutions have begun to do exactly that. They are predominantly outside the United Kingdom and United States, most notably in Canada, some Scandinavian countries, and in Asia Pacific. The Ontario Teachers’ Pension Fund in Canada, PGGM in the Netherlands, and the Norwegian and Singaporean sovereign funds are often cited as examples.
There are three things that distinguish engaged institutional investors from their more conventional counterparts. The first is that they hold significant share blocks in particular companies for extended periods of time. Second, since they hold rather than trade these blocks, they do not need to employ intermediary fund managers; instead, they either manage the investments directly themselves or actively evaluate fund managers against a longer and broader set of criteria than short-term financial returns; and third, they invest significant amounts in developing the necessary in-house expertise to perform these functions.
Dominic Barton describes how two long-term engaged investors incentivize their managers:
Consider the example of GIC, the Singaporean sovereign wealth fund, which explicitly takes a twenty-year view on incentives and performance measurement. Its key performance metric at the aggregate-portfolio level, used as the basis for incentives, is the twenty-year rolling rate of return, while its minimum horizon for performance measurement is five years. Similarly, the Canada Pension Plan Investment Board has moved to five-year rolling returns as the benchmark for rewarding its managers.12
In other words, these institutions demonstrate a commitment to long-term equity ownership as against traditional short-term portfolio management. This does not require them to forgo the benefits of portfolio diversification because, alongside the concentrated holdings in a segment of their portfolio, they can retain diversified investments (e.g. index funds) in the remainder.
A key function of institutional investors is participation in the appointment and replacement of board members. Monitoring and evaluation of board performance is important but initial care in the selection of board appointments even more so. The reason for this is that the board is the custodian of corporate purpose. In contrast to a shareholder primacy view of the firm, corporate purpose does not reside with financial institutions or the market for corporate control. It is the responsibility of the board, as the elected representatives of the relevant constituents of the company, to define and execute corporate purpose.
In the United Kingdom, directors are formally elected at shareholder meetings on the basis of recommendations of nomination committees of independent directors and are therefore largely self-selected by their own boards. In Sweden, the nomination committee is external to the board and comprises representatives of the largest shareholders. Sweden is a particularly interesting comparison to the United Kingdom because, in contrast to many other Continental European countries, it, like the United Kingdom, has a strongly shareholder-oriented system.13 However, its pattern of share ownership is very different from the United Kingdom with a much greater prevalence of block holders than in the United Kingdom. The existence of an external nomination committee in Sweden is a reflection of large and long-term shareholdings but it is also an inducement to it since the committee provides a forum in which the largest shareholders can express ‘voice’ about the composition of the board. There are therefore strong incentives on investors to acquire and retain share blocks to gain seats on the powerful nomination committees.
The concern that external nomination committees raise, in particular in the United Kingdom, is that they undermine their independence and make them prone to capture by large shareholders at the expense of minority shareholders. However, it may be possible to combine the benefits of active engagement by large shareholders in the Swedish external nomination committee with the board independence associated with UK internal committees through including both internal and external members on hybrid nomination committees. They could also have representatives of other parties such as employees, communities, and government in more stakeholder-oriented companies.
A particularly interesting class of long-term engaged owners is industrial foundations, which are widespread in even the largest companies in Denmark and Germany. Industrial foundations are companies that do not simply possess foundations but are owned by them; examples include Bertelsmann, Bosch, Carlsberg, Ikea, and Novo Nordisk. By conventional criteria these companies have all the symptoms of the worst forms of corporate governance—self-appointing boards that are not rewarded on performance or subject to an external market for corporate control. And yet on average their financial performance is as good as that of other similar companies. In fact, in some respects it is better;14 they have stronger reputations and sounder labour relations and most strikingly of all, they survive: the average length of life of industrial foundation firms is some three times greater than that of other equivalent firms. A concern that is sometimes raised about industrial foundation firms is the self-selection of foundation board members. A hybrid system of board election by nomination committees comprising both internal foundation and external shareholder members might help to address this concern.
What does the empirical evidence suggest? Does purpose or profit produce better financial performance? Is long-termism good or bad? Is sustainable, stakeholder business better than shareholder business? Does doing good do well?
There has been a massive outpouring of empirical studies focused on precisely these issues.15 A decisive study of a relation between responsibility and performance is the Holy Grail to which the business and financial academic community is working frenetically. But like the quest for the Holy Grail, it is proving a bit more elusive than might have been hoped.
On the plus side, there is mounting evidence that if one invests in portfolios of purposeful, sustainable, socially minded corporations and is willing to hold them for a sufficiently long period of time, then one can comfortably outperform their less enlightened and ethically sound counterparts.16 But one also does well with instant gratification investing in ‘sin stocks’ engaged in gambling, alcohol, tobacco, arms, fossil fuels, and sex. While goodness might be rewarded in heaven, badness appears to have faster (if not such enduring) pay-offs closer to home.17
There have been studies examining the relationship of corporate social responsibility (CSR),18 corporate sustainability,19 customer satisfaction,20 eco-efficiency,21 environmental, social, and governance (ESG) factors,22 and materiality23 to stock returns, risk equity cost of capital, and merger stock returns.24 They report that CSR, corporate sustainability, customer satisfaction, eco-efficiency, ESG, and materiality are associated with higher returns, lower risk, and lower costs of capital. There is evidence of a positive relation between employee satisfaction,25 corporate cultures of integrity,26 and stock returns, at least over the long run. There is evidence that highly trusted organizations are associated with greater decentralization of investment, hiring, and sales decisions.27 These studies are careful to control for other factors that might be influencing the results and in identifying directions of causation from different forms of responsible business to performance not vice versa. There is, in other words, a clear relationship between good business practices and financial returns for shareholders.
If there are such clearly good, beneficial, and profitable management practices, why are they not universally adopted? Why is there such a deficit and deteriorating level of trust, meaningful work, and corporate environmental protection? In answering these questions, we should note that the criteria by which the above studies judge performance are financial returns and costs of capital. They are using profit as their measure of success. It is the same as presuming that the yardstick by which to measure human happiness (utility) is wealth. It is sometimes for some people but it certainly is not always for everyone. The reason why is similar to the reason why shareholder value is not always and everywhere the relevant yardstick, and that is it depends on circumstances.
Shakespeare’s seven ages of man quoted at the beginning of Chapter 1 illustrate: ‘At first the infant, | mewling and puking in the nurse’s arms’—human capital; who becomes the whining schoolboy seeking friends—social capital; then the lover—human capital; who needs to earn income for his family as a soldier—financial capital; and progresses to become a justice worried about his social standing—social capital; before becoming an old man worried about his health—human capital; before the last scene of all—‘sans everything’—spiritual capital.
At each stage the relevant objective to be maximized (the maximand) changes. It moves from being personal human capital to social, to family human, to financial, back to social, and finishing with human capital. So if we posed the question does a focus on purpose in our lives lead to a positive association with financial capital, the answer would be unequivocally not always. We are not predominantly focused on it for most of the ages of our lives and quite willing to sacrifice it for other goals. It is not just that ‘money can’t buy you love’ or health or status or happiness, it is that at most stages of our lives our maximand is something quite different.
So too with the six ages of the corporation, also described in Chapter 1: at first the merchant trading company operating under royal charter, opening up voyages of discovery around the world––social and material capital; then the public corporation with its hoards of labourers—social and human capital; then the private company and the rise of manufacturing—financial and material capital; the fourth age is the service firm and the rise of financial services—human and financial capital; the fifth age is the transnational corporation with its gleaming global headquarters running rings around nations—financial, human, and material capital. The last scene of all is the mindful corporation sans everything—human and intellectual capital.
So financial capital has featured prominently in three ages of the corporation but is rapidly losing its pre-eminence in the sixth age of the corporation. Instead human and intellectual capitals are of much greater significance. But as we come out of the previous ages, we are also left with a legacy of depleted natural and social capital. So the major constraints on the seventh and final age of the corporation as the trusted corporation are a combination of human, intellectual, natural, and social capital.
The importance of this stems from the fact that it means that the relevant maximand in many cases is no longer financial capital. It has moved on to a combination of human, intellectual, natural, and social capital. This has profound implications for corporate governance and control because it is these capitals that are constrained and have to be allocated to their most efficient use, and this requires control by the relevant party over their allocation. So where human capital is most heavily constrained then employee ownership is appropriate. Where intellectual capital is critical then the allocation of control to entrepreneurs or founders is required, and where social capital is deficient then local or public ownership may be appropriate.
New technologies are fundamentally altering the governance of firms. For example, through influencing the way in which the prices of shares are set in stock markets, high frequency trading is affecting resource allocation in corporations and intensifying a focus on short-term share-price fluctuations. Small increases in the speeds at which high-frequency trades are undertaken have been found to yield significantly higher and persistent profits for the trading firms that execute them.28 New technologies therefore create substantial private incentives to engage in activities that may have few, no, or possibly negative social benefits associated with them. Corporate governance cannot remain oblivious to such social consequences of new technologies and, with the arrival of artificial intelligence, it is not just that the scale of the effects will become even greater but the source of decisions may move from the minds of men to machines as company board decisions themselves are automated.
There can then be no presumption that shareholder control is always and everywhere optimal or that shareholder value is in general the appropriate criteria by which to measure performance. Where the constraints of other forms of capital are greater then it is in relation to these capitals that we should expect value to be maximized and performance to be best. In such circumstances, while financial capital should not be depleted, it is not necessarily optimized either and may in some measure be sacrificed for the enhancement of other forms of capital.
This suggests some fundamental principles of corporate governance. The first relates to ascertaining which capitals should be exercising corporate control and therefore what capital values should be maximized:
Principle 1: Corporate control should be exercised and value maximized by scarce capitals.
So corporate control should reside with those capitals that are in short supply because it is those that will have to be allocated to activities of maximum value. In the absence of frictions, total corporate value, defined as the sum of values of different forms of capital, will be maximized when control is allocated according to principle 1.
In practice, frictions to the allocation of control are created by legal, regulatory, political, and social factors. In particular, there will be resistance to reallocations of control that affect distribution of power and wealth by those whose influence will diminish as a consequence. These parties will use their political and social influence over law and regulation to impede transfers of authority. This suggests the second principle of corporate governance relating to measures of performance defined in terms of total capital value:
Principle 2: Total corporate value will deteriorate where law and regulation impede appropriate transfers of control.
Transfers of control are required to respond to external influences, such as changing technologies, social pressures, and environmental constraints that alter the nature of capital constraints. For example, the Internet has diminished constraints on hotels and taxis, by facilitating sharing of private properties and automobiles, and on hoteliers and taxi drivers, by employing part-time drivers and landlords, while increasing requirements for others, for example the skilled labour involved in designing the computer applications that manage the sharing economy. The transfers of control that these changes demand are inevitably resisted by the losing parties who seek political and social support for laws and regulations that impede them.
An interesting illustration of this was the event that caused the suppression of dual-class shares in Britain described in Chapter 4. Dual-class shares and takeover defences featured prominently for a brief period of time in Britain in the 1960s when companies attempted to defend themselves against the newly emerging market for corporate control—hostile takeovers:
These takeover defences met with stiff opposition from an influential quarter––the institutional investors and the London Stock Exchange. They were concerned about the interference with the takeover process, the ability of management to entrench itself behind takeover defences and the withdrawal of their voting rights. Under pressure from the institutions, the Stock Exchange made it known that it disapproved of the use of dual class shares and would not permit their use in new equity issues. The intervention of the institutions and the Stock Exchange proved decisive and during the 1970s and 1980s companies steadily withdrew dual class shares.29
Unconstrained transfers of control can indeed be total value diminishing if the gainers cannot compensate the losers. In other words, they risk value diversion, i.e. making one party better off at the expense of another, rather than value creation, i.e. increasing the total size of the pie. To avoid this, profit should only be recorded after all the costs associated with compensating losers have been accounted for. So, for example, there is only a total surplus resulting from the sharing economy if there is a profit after compensating for the losses sustained by taxi drivers and hoteliers. This suggests a notion of capital maintenance by which provision has to be made for the costs of maintaining all forms of capital (human, natural, and social) as well as that of existing controlling capitals (financial and material):
Principle 3: Profit should be measured net of total capital maintenance associated with sustaining all forms of affected capital.
We return to illustrate the application of this third principle in Chapter 6. It suggests that there are limitations to the degree to which the controlling party can exploit their positions. This is reinforced by the observation that throughout the six ages of the corporation, more than one type of capital is scarce. This has been particularly pronounced recently with all of human, intellectual, natural, and social capital being arguably scarce to varying degrees in different corporations.
Together, the above principles have several implications. First, existing studies are deficient in focusing exclusively on financial performance for shareholders. In an era of diminishing financial constraints and increasing financial abundance, such studies are of limited relevance and, until a wider set of measures beyond financial returns is available, it will be difficult to undertake reliable tests of performance. This emphasizes the importance of being able to extend measures of capital beyond financial capital to include human, intellectual, natural, and social capital.
The second implication is that in light of the co-existence of multiple forms of scarce capital and the need to protect the interests of abundant as well as scarce capital, controlling parties have the responsibilities of trustees to act on behalf of multiple parties not just themselves. As noted in Chapter 1, corporations are commitment not control devices that are required to uphold the interests of multiple not single parties. That is why the institutions of trust were so important in the development of corporations during the twentieth century described in Chapter 4.
This conclusion is particularly relevant to natural capital. It is only over the last few decades that the constraint imposed by natural capital has become evident; before then it did not feature prominently at all. But we now recognize the problems created by consuming at the expense of nature and future generations. How do we allocate control to natural capital? Do we put the rhinoceros or the giraffe in charge of our multinational corporations? How do we give the unborn a voice at our annual general meetings?
In Firm Commitment I discuss the problem of what is termed ‘the tragedy of the commons’, which involves overgrazing of the commons by current generations at the expense of future generations. The solution I suggested there involves giving young generations the authority to allocate grazing rights to older generations. Realizing that (a) what they will inherit will depend on how much they allocate today but (b) they will be the next older generation and therefore dependent on the wisdom of the generation beyond them, they exploit neither the commons nor the older generation. In contrast, if control is allocated to the older generation then the younger generation is entirely at the mercy of the altruism of their seniors.
There are therefore two possible solutions to the protection of natural capital. The first is to allocate control rights predominantly to younger generations of owners and require them to relinquish control to their successors as they age. The second is to put natural capital ownership in trust of older generations whose concern about their reputation will make them take their role as custodians seriously with the proper interest of future as well as current generations in mind. A recent example of the latter is the Whanganui River in New Zealand, which in March 2017 became the first river to be granted legal status as a Te Awa Tupua, an indivisible, living whole, with two guardians, one from the Crown and one from the Whanganui River Maori community.
The three principles described above account for recent observations of corporate forms ‘going private’, seeking to be more adept at responding to new opportunities by removing the restrictions imposed on them by public equity markets. They provide an explanation for the observations made repeatedly throughout the book of the apparent success of corporate forms, such as cross-shareholdings, industrial foundations, and pyramid structures, which on conventional shareholder-value principles should have been unmitigated disasters. They are consistent with the persistence and continuing dominance of families employing control devices such as dual-class shares that allow idiosyncratic values to be sustained in the face of their apparent detriment to shareholder value. They explain the rise of the Middle East on the back of its commercial lead in adopting partnerships and then its decline in failing, for a mixture of political, religious, and social reasons, to adopt the corporate forms that were emerging elsewhere. They are associated with a country with historically one of the strongest levels of investor protection and shareholder primacy, the United Kingdom, declining progressively in economic status over the last hundred years relative to one with some of the weakest, Germany.
Above all they bring us to the heart of the problem with the Friedman doctrine. It is not the notion of making profits or even prioritizing profits that is at fault. It is the way it has morphed into an obligation on companies to maximize profits and achieve greater profits than other firms at all times that has been the source of corporate failure. It drives companies to extremes of seeking the pursuit of shareholder value at the expense of all and everyone else, resulting in abuses and erosion of trust. The rise of the market for corporate control in the form of takeovers and institutional activism is the reason why the problem has been most acute in the United Kingdom and the United States with their dispersed forms of ownership and absence of anchor shareholders to moderate its effect. And the inability of firms in the United Kingdom to adopt takeover defences has made the problem even more acute there than in the United States.
Recent ideas on conscious, inclusive, mutual, purposeful, shared business capitalism and economies all have their merits in promoting better practices and processes but none of them are inconsistent with the Friedman doctrine of pursuing profits and none get to the heart of the problem. It is the manifestation of the doctrine in the unrelenting drive to greater profits that is the source of its deficiencies and its consequential undermining of the ability of management to act ‘reasonably’. It is not that directors are angels dancing at the heads of corporations, but that their vision has been clouded by the persistent pre-eminence of shareholder value.
Definitive support for the principles must await more specific testing of, for example, impacts of external influences such as technological, social, political, legal, and regulatory changes on allocations of corporate control in organizations. However, even without such evidence they appear to provide a coherent account of much of what history and experience from around the world has to tell us about the way in which corporate ownership, governance, and management affect the performance of firms.
The purpose of governance is the governance of purpose. Superficially doing well by doing good would appear to be a problem of management. There are unrecognized and unmeasured benefits from promoting human, social, and natural capital as well as financial capital, and there are problems of managing companies’ supply and distribution chains to realize these benefits.
Complex though these are, there is more to doing well by doing good than just measurement and management. There are still greater challenges at the top of organizations in legitimizing and advocating these approaches to business. They demand a commitment of leadership that flies against conventional wisdom and frequently faces stiff resistance from lower down in the organization. For a business to do well by doing good it requires the board to take charge of creating a conducive corporate culture throughout the organization from the board to the shop floor, from the workplace to the fields and slums of the supply and distribution chains. And it is not just the board that needs to be committed, so too do the owners.
This is why what appears to be a matter of management is actually a challenge of corporate governance. Corporate governance is about the structure and conduct of the ownership and control of companies to fulfil corporate purpose. It lies at the heart (cor) of the body (corpus) and head (caput) of the corporation. It governs how the purpose and values of the business are translated into actions in the organization that are transmitted into value for investors. Along with ownership, law, and regulation, the absence of purpose from the centre of corporate governance is a primary reason why firms fail to deliver on purpose.