Criticisms of shareholder and stakeholder debate

“...the company, as an artificial person, can have no interests separate from the interests of those who are associated with it, whether as shareholders, creditors, employers, suppliers, customers or in some other way. So, the crucial question is, when we refer to the company, to the interests of which of those sets of natural persons are we referring? Of course, one could take the view that the beauty of referring to the interests of the company, without any further specification of what is meant, is that the answer to my question is left wholly ambiguous and obscure." (Professor Paul Davies in the lecture at Melbourne University, October 2005)

Whose interests do you think the company serves and why? Critically discuss.

Introduction

Determining the corporate objective has been debatable for many years in many places. Generally, a corporation is a group of members formed by the shareholders, as well as other groups like employees, suppliers and customers who all have different contributions to the success of the corporation. However, it is undoubtedly “ambiguous and obscure" as mentioned by Professor Paul Davies when ascertaining whose interests ought the company to be run, as it is difficult to determine which groups’ interests should override the others and is of utmost importance to a company. In fact, there have been two schools of thought put forward in relation to the corporate objectives. They are the shareholder value principle, which argues that the company’s objective is to maximize the shareholder interests; while the other one is the stakeholder theory, which provides that the company should serve not only for the betterment of the shareholders, but also the interests of different stakeholders such as employees, customers and creditors.

This essay seeks to determine which constituency’s interests the company should promote by exploring and analyzing under different approaches. In the next part, the meaning of “company’s interests" will be discussed with regard to local guidelines and common law cases. In part 3, we will examine the company interests under the shareholder value principle as well as the stakeholder theory, followed by an evaluation on the new “enlightened shareholder value" approach which emerged as a balance of the two approaches aforesaid in Part 4. Finally, a conclusion will be drawn in the last part of this paper.

The meaning of “company’s interests"

In fact, the Hong Kong Companies Registry has updated the non-statutory guidelines on the directors’ duties in 2009, which has set out in the first principle that the director has a duty to “act in good faith for the benefit of the company as a whole". It continues to elaborate that the “company’s interests" refers to “the interests of all of the company’s shareholders, present and future." [1] Apart from the local non statutory implication, it is also viewed by the majority in the context of common law that “company" refers to shareholders, thus interests of the company are to be equated with “the interests of the general body of shareholders". [2] 

However, it has been argued that the shareholder’s interests should not be the exclusive focus of the directors, but something beyond. [3] According to the case in Brady & Anor v Brady & Anor [4] (Brady), it is mentioned by Nourse L.J. that “the interests of a company, an artificial person, cannot be distinguished from the interests of the persons who are interested in it." This has actually broadened the concept of “company’s interests" that it embraces the interests of other individuals who also participates in the corporate entity. Consequently, there is no definite answer as to what conceives the interests of a company. Nevertheless, we may have better clues by evaluating the best interests of the company under different approaches in the next part.

The shareholder and stakeholder debate

The debate between the shareholder and stakeholder concepts has emerged over the last decades. The shareholder approach believes that shareholder’s interests should be the focus of a company, which is a “dominant principle in corporate law". [5] On the contrary, the stakeholder approach takes a view that the directors should balance the interests of different constituencies that make up the company, rather than considering the sole interests of shareholders. We shall examine the arguments of both approaches and critically analyze the drawbacks of their approaches in this part of the paper.

The Shareholder Approach

The shareholder approach is also named as the shareholder primacy model, and the core concept is that the ultimate objective of a company is to maximize wealth for shareholders. This concept has been put forth earlier in Dodge v Ford Motor Company [6] , which provided the primary legal support for the shareholder primacy model. Further advocated by Professor Berle, directors should be obliged to act exclusively in the interests of shareholders [7] , which is also regarded as “the substance of the corporate fiduciary duty". [8] In general, there are three major arguments in favour of the shareholder primacy model.

The primary argument in favour of this approach is that shareholders are the “residual claimants" when the company is solvent. It is believed that a company should be accountable for the benefit of the residual claimants, as shareholders being the equity investors are the “greatest stake in the outcome of the company" [9] . They may benefit from the company’s surplus, but also bear a greater risk than other constituencies as their interests are not adequately protected by contractual means under most circumstances. Thus, they should be given a right to control above other stakeholders because their interests are associated with every decision they made for the firm. Unlike shareholders, interests of non-shareholder constituencies are better protected by legal mechanisms like contract law, rather than an involvement in corporate governance. [10] 

Secondly, it is the reduction of agency costs. Under the agency theory, it is known that the agent, namely the directors, should act on behalf of the shareholder’s interests in running the business of a company [11] . However, in the absence of the shareholder primacy, it is likely that the directors will “shirk" their duties and agency costs will be incurred to monitor their work so as to prevent their abuses in positions. In order to reduce the agency costs, the effective way is to uphold the shareholder value that directors are made accountable to shareholder’s interests.

Finally, it is believed that directors can make better corporate decisions if they are focused solely on shareholder’s interests. As if directors owe duties to other non-shareholder constituencies, it would not be possible for them to balance all of the diverging interests. [12] Besides, it is apparently incapable for the court to formulate and enforce fiduciary duties to ensure that the directors act fairly and make decisions more efficiently in the interests of all stakeholders. Hence, the shareholder primacy model is more certain and easier to administer as compared with the stakeholder approach.

The Stakeholder Approach

According to the prominent proponent of the stakeholder theory, Professor Freeman, “stakeholders" are defined as “groups and individuals who can affect, or are affected by, the achievement of the organization’s mission." [13] Thus, the directors should run a firm not only for the benefit of shareholders, but all potential stakeholders that make up the company, such as employees, customers, creditors, suppliers as well as the local community. We shall look into the importance of considering the stakeholder’s interests in the following parts.

3.2.1 Creditor’s interest

Unlike other constituencies, creditor’s interests are taken into account by the company only when the company is in a state of insolvency or financial difficulty as there is a substantial risk that it may be unable to discharge its debts. It is supported by various common law cases that the duties of directors would shift from shareholders to creditors under such circumstances. For instance, Nourse L.J. has mentioned in Brady’s case that “where the company is insolvent, or even doubtfully solvent, the interests of the company are in reality the interests of existing creditors alone." [14] Reaffirming Nourse L.J.’s reasoning in West Mercia Safewear Ltd v Dodd [15] , it is also suggested that directors ought to consider the interests of creditors in making decisions when the company is in times of financial difficulty.

Nevertheless, creditor’s interests will become paramount only where the company is insolvent or nearing insolvency. Therefore, it is unlikely that the interests of creditors would be an exclusive focus of the company under normal situation, and director’s duties are likely to protect rather than to promote their interests.

3.2.2 Employee’s interest

Employees are considered to have an interest in the company as they contribute their work, skills and knowledge at present in receipt of benefits such as pension provided by the company in future. [16] Besides, human capital is often regarded as a kind of investment of the company, which is particularly applicable to some high technology industries as technological innovation requires significant contributions made by employees. As a result, directors should consider the interests of employees in the sense that they are a key group of stakeholders who can promote competence and enhance sustainability of the companies they worked for.

3.2.3 Customer’s interest

Customer’s interests should not be neglected by the directors as they are important assets of the company. A good example to illustrate the importance of a company to consider customer’s interests is the success story of Toyota in the U.S automobile markets. As the U.S automobile makers failed to meet the changing consumer demands by continuing to produce large and fuel-inefficient automobiles, consumers had eventually switch to smaller and more fuel-efficient Japanese models. This has made Toyota’s market value worth more than twice the combined market value of the big three U.S automobile makers as of 2005. [17] Hence, customers constitute an important stakeholder group for they are crucial to a company’s success.

3.2.4 Other stakeholder group’s interests

Stakeholder groups such as suppliers do have interests in the company, as they will make some firm-specific investments for the needs of particular customers, and they are likely to share the surplus generated by the company. [18] For suppliers are crucial factors of production, it is important for companies to establish stable trading relationships within the supply chain. Apart from that, companies are considered to have social responsibility as their corporate decisions may affect the community at large, therefore interests of the community should be recognized in their commercial activities.

Criticisms of the two approaches

Considering the arguments for the shareholder primacy model and the stakeholder approach, there are several flaws that made the approaches less persuasive in general.

Regarding the shareholder primacy model, it is rather misleading to argue that the shareholders are the sole “residual claimants" in the company, especially under circumstances when the company is not in bankruptcy. It is not the shareholder’s firm-specific investments that made their position more vulnerable when compared to other stakeholder groups. As employees, suppliers and other constituencies have contributed to the firm’s success and they suffer as well when the company performs poorly. In reality of a public company, it is also the decision made by the board of directors in controlling whether dividends should be paid to shareholders or used to raise the earnings for employee’s salaries and other purposes. [19] Thus, it is not justified to focus solely and protect the shareholder’s interests based on the argument that they are the only residual risk-bearers.

For the stakeholder theory, the primary criticism is that it fails to deal with the problem of balancing the potential conflicting interests of all different constituencies. Even so, there is no way for the stakeholders to claim for any failure on the part of the directors. Moreover, there is no clear boundary for the stakeholder groups to be considered by a company, the problem has been addressed by Professor Sternberg that a company being accountable to everyone, is actually accountable to no one. [20] 

It is of my view that neither of the approaches are convincing in the sense that the shareholder approach focuses on implementation but neglected justification, and it is vice versa for the stakeholder approach in addition to their problematic arguments. In fact, these approaches can supplement each other in order to come up with a generally accepted principle, thus a new approach has emerged as the “Enlightened Shareholder Value", which will be discussed in the next part.

The Concept of “Enlightened Shareholder Value"

The “Enlightened Shareholder Value" (ESV) approach is actually based on the shareholder primacy model that the ultimate objective of a company is still promoting shareholder’s benefits. Yet the heart of this approach is considered to be more enlightened and balanced because directors are obliged to “achieve the success of the company for the benefit of the shareholders by taking proper account of all the relevant considerations for that purpose". [21] The “relevant considerations" include sustaining long-term relationships with employees, customers and suppliers, as well as the impact of company’s activities on the community.

The ESV approach has also been successfully adopted in the Companies Act 2006 (UK) (the Act) after the inclusion of it in the Company Law Reform Bill in 2005. It is clearly stated under section 172(1) of the Act that directors only owe duties to act in the interests of shareholders, yet they seek to consider a broader range of matters in order to fulfill that duty. [22] This new approach is adopted by the British government because it has reflected the modern view of “corporate social responsibility", such as rejecting business planning that would raise profits at the expense of the local community. [23] This view has also been advocated by Professor Jensen before the emergence of the ESV approach [24] , that the way to maximize a company’s long-term market value is through the fostering of sustainable and co-operative relationships with various stakeholder groups. One can easily imagine that a shareholder is unlikely to benefit from a company with unstable supply from their suppliers; their products disliked by the customers or even continuous striking by their employees.

It is personally opined that focusing mainly on shareholder’s wealth maximization is generally the most effective way to achieve the broader goal of promoting overall social benefits. The company is also likely to make more responsible corporate decisions by considering the interests of other constituencies and the community in which they operated. Accordingly, the ESV approach is a more balanced and generally accepted approach that it merges elements of the shareholder primacy model and the stakeholder theory.

Conclusion

A company should serve the interests of constituencies who have the most stakes in the well-being of their business. However, the constituency in question can arguably be the shareholders or other stakeholder groups under the interpretation of different approaches. As a matter of fact, it is difficult to have a clear guiding principle to whose interests the company should serve even today, because of the ongoing developments of the society, insertion of more firm objectives…etc. The ESV approach maybe applicable to corporations nowadays due to the prevailing firm objective of “corporate social responsibility", yet this may not be the case in the future as our society is becoming more volatile.

Considering all the above, it is not possible to adopt a single approach for corporate objectives all the time, as the stakeholder group who is mostly important to a company at a certain time does not equally means the same at other times. Instead, Professor Paul Davies’s question should be remained for the company directors to determine “the best interests of the company", depending on their business nature, the socio-economic condition and other relevant considerations at that particular time.

BIBLIOGRAPHY

BOOKS

Christine A. Mallin, Corporate Governance (Oxford University Press, Oxford 2004)

Elaine Sternberg, Corporate Governance: Accountability in the Marketplace (2nd edn Institute of Economic Affairs, London 2004)

R. Edward Freeman, Strategic Management: A Stakeholder Approach (Pitman, Boston 1984)

Stephen Griffin, Company Law: Fundamental Principles (3rd edn Longman, Harlow 2000)

ARTICLES/ REPORTS

Adolf A. Berle, ‘Corporate Powers as Powers in Trust’ (1931) 44 Harvard Law Review 1049.

Andrew Keay, ‘Tacking the Issue of the Corporate Objective: An Analysis of the United Kingdom’s ‘Enlightened Shareholder Value Approach’’ (2007) 29 Sydney Law Review 577.

Eugene F. Fama and Michael C. Jensen, ‘Separation of Ownership and Control’ (1983) 26 Journal of Law and Economics 301.

H. Hansmann and R. Kraakman, ‘The End of History for Corporate Law’ (2001) 89 Georgetown Law Journal 439.

John Kong Shan Ho, ‘Economic Theories of the Firm verus Stakeholder Theory: Is there a Governance Dilemma’ (2008) 28 Hong Kong Law Journal 399.

Jonathan R. Macey, ‘Fiduciary Duties as Residual Claims: Obligations to Nonshareholder Constituencies from a Theory of the Firm Perspective’ (1999) 84 Cornell Law Review 1266.

Lynn Stout, ‘Bad and Not-so-Bad Arguments for Shareholder Primacy’ (2002) 75 Southern California Review 1189.

Margaret M. Blair and Lynn A. Stout, ‘A Team Production Theory of Corporate Law’ (1999) 85 Virginia Law Review 247.

Mark E. Van der Weide, ‘Against Fiduciary Duties to Corporate Stakeholders’ (1996) 21 Delaware Journal of Corporate Law 27.

Matheson J.H and B.A Olson, ‘Corporate Law and the Longterm Shareholder Model of Corporate Governance’ (1992) 76 Minnesota Law Review 1313.

Michael C. Jensen, ‘Value Maximization, Stakeholder Theory and the Corporate Objective Function’ (2001) 7(3) European Financial Management 297.

Thomas A. Smith, ‘The Efficient Norm for Corporate Law: A Neotraditional Interpretation of Fiduciary Duty’ (1999) 98 Michigan Law Review 214.

ELECTRONIC SOURCES

Companies Registry, ‘A Guide on Directors’ Duties’ (2009):

<http://www.cr.gov.hk/en/publications/docs/director_guide-e.pdf> accessed 7 October 2010.

The Company Law Review Steering Group, Department of Trade and Industry, Modernising Company Law: The Strategic Framework (1999): <http://www.berr.gov.uk/files/file23279.pdf> accessed 8 October 2010.

CASES

Brady & Anor v Brady & Anor [1987] 3 BCC 535, 552.

Dodge v Ford Motor Company [1919] 204 Mich. 459, 170 N.W. 668.

Fulham Football Club Ltd v Cabra Estates plc [1992] BCC 863.

West Mercia Safewear Ltd v Dodd [1988] 4 BCC 30.