Harvard University researchers have proposed a governance model that better balances the needs of shareholders and stakeholders, and expands the board’s focus on the organisation’s long-term health rather than its short-term returns.
In the May-June 2017 Harvard Business Review, Professor Emeritus Joseph Bower and Professor Lynn Paine argue for a company-centred model of governance that recognises the diversity of shareholder goals and the varied roles corporations play over long periods.
“The time has come to challenge the agency-based model of corporate governance,” they write. “Its mantra to maximising shareholder value is distracting companies and their leaders from the innovation, strategic renewal and investment in the future.
“History has shown that with enlightened management and sensible regulation, companies can play a useful role in helping society adapt to change. But that can only happen if directors and managers have sufficient discretion to take a longer, broader view of the company and its business. The prospect of a surprise attack by unaccountable ‘owners’, [means] today’s business leaders have little choice but to focus on the here and now.”
Bower and Paine’s view is timely for Australian boards. Led by ANZ Banking Group chairman, David Gonski AC, FAICD, the governance community attacked the growing trend of short-termism by investors, analysts and the media, at the 2016 AICD Governance Summit.
A recurring theme is boards wanting greater focus on long-term value creation; more engagement in strategy creation, implementation and governance; and scope to better balance the needs of shareholders and stakeholders, by ensuring their organisation has robust environment, social and governance (ESG) performance.
But market demands for higher shareholder returns risk turning boards into overseers of short-term thinking rather than long-term custodians who act in the best interests of the corporations, all shareholders and the community.
The growth of shareholder activism offshore and, more recently, in Australia is intensifying pressure on boards to respond to market demands for new strategies or management changes in the organisation. The high turnover/low tenure of CEOs in developed markets is symptomatic of the pressure on corporations to achieve short-term returns.
As the market demands higher returns, corporations must work hard to maintain and strengthen their “social licence” to operate, by balancing the needs of shareholders and stakeholders and ensuring their organisation adds to the community or does no harm.
Industries that are offside with the community are vulnerable to higher governance regulation and taxes. The Federal Government’s surprise proposed $6.2-billion bank levy is the latest example. Commonwealth Bank chair, Catherine Livingstone, AO, FAICD, reportedly said, “Which sector will be next?”, when asked about the levy in May 2017.
Is the agency-based model of governance outdated?
Bower and Paine say the agency model of governance is the root cause of market short-termism. Under agency theory, shareholders are best protected when board and management roles are separate. Independent boards safeguard against opportunistic management behaviour and potential “agency loss”. Agency theory implies that boards are there to keep watch on management and that directors have a supervisory role.
The authors argue that agency theory is flawed. They dispute that shareholders are “owners” of corporations given that they legally do not have the rights of owners (such as using company assets).
Moreover, they contest that managers and directors are agents of shareholders. Rather, they are fiduciaries who are obligated to exercise independent judgement to act in the best interests of the corporation, not simply to do shareholder bidding.
Aligning management and shareholder interests – a hallmark of agency theory that is grounded in contemporary governance practices such as executive pay – is misguided, say Bower and Paine. “When the interests of successive layers of management are ‘aligned’ in this manner, the corporation may become so biased toward the narrow interests of its current shareholders that it fails to meet the requirements of its customers or other constituencies. In extreme cases, it may tilt so far that it can no longer function effectively.”
At its core, the company-centred model of governance says corporations are independent entities endowed by law; that management’s authority comes from the governing body and ultimately the law; and that managers are fiduciaries (rather than agents) and obliged to act in the best interests of the corporation and shareholders – a different approach to carrying out the wishes of even a majority of shareholders.
The authors believe the success of organisation leaders is more to do with intrinsic motivation, skills, character and capabilities, than whether their pay is tied to shareholder returns. They argue that corporates must continually adapt through innovation, perform many functions, have differing objectives and strategies, multiple constituencies, require high ethical standards, and are embedded in a political and socio-economic system.
Bowers and Paine write: “These propositions underscore the need for an approach to governance that takes the corporation seriously as an institution in society and centres on the sustained performance of the enterprise. [In this model] boards and business leaders would take a fundamentally different approach to such basic tasks as strategy development, resource allocation, performance evaluation and shareholder engagement.”
Market is validating broader governance approach
The company-centred model of governance makes an important contribution to the global governance debate. The market, it seems, is vindicating the authors’ view as more capital is allocated to responsible companies with higher ESG ratings. Put another way, stronger governance is driving higher returns for investors and attracting capital.
In Australia, responsible investment constitutes $633.2 billion, or almost half of all assets professionally managed, according to the latest Benchmark Report from the Responsible Investment Association Australasia. Responsible investing has a systematic approach to incorporating ESG and ethical issues into financial decisions.
As superannuation funds show greater interest in ESG, they are requiring the same of fund managers who invest superannuation capital. That, in turn, is pressuring financial intermediaries, such as investment banks, to increase their focus on analysing corporate ESG performance and factor it into investment recommendations.
A growing body of academic research confirms higher returns from responsible investing. In 2016, Harvard University researchers Sakis Kotsantonis, Christopher Penney and George Serafeim wrote: “Companies committed to ESG are finding competitive advantages in product, labour and capital markets, and portfolios that have integrated ‘material’ ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk.”
The takeout is clear: companies with higher ESG ratings are, on average, outperforming their peers and attracting more capital. It is no longer a question of boards trying to balance the needs of shareholders and stakeholders. Governing in the best interests of the corporation, shareholders and the community is not just the right thing to do, it’s smart business.
Enlightened shareholders understand the need for boards to look beyond short-term investor needs, often championed by a narrow group of shareholders or activists, for the long-term benefit of all shareholders, the corporation and society.
Ironically, it might be the market that settles the debate between different governance models. The agency model favours shareholder activists who target companies that are not producing sufficient short-term returns. The company-centred model, with its broader focus, favours long-term investors who look beyond financial returns.
Although shareholder activism creates headlines, it is long-term investors (represented by super funds) who want a broader governance style and should have the ultimate say.
To read the Harvard Business Review article in full, follow this link: