Navigating business ethics

Governance Leadership Centre (GLC): What do you believe are the key ethical issues that Australian directors and boards face today?

Simon Longstaff (SL): Firstly, Australian directors need to come to terms with the move by many groups, including regulators, to identify culture as a critical issue for boards. Many people seem not to realise that all culture is built on a foundation of ethics. Culture – the way that things “get done” – is the product of people making day-to-day choices such as “I’ll do this because I think it’s good or better than the alternative” or “I’ll do this because I think it’s right rather than wrong”. The language of “good” and “bad”, “right” and “wrong” is the language of ethics – a universal grammar that underpins all human choice and thus all that we make and do.

If you don’t manage culture and ethics in a conscious and active sense, the underlying structure and foundations of an organisation can begin to corrode or become corrupted. There’s also an opportunity cost. Research consistently shows that the way to unlock employees’ discretionary effort is by giving a clear sense of what the organisation stands for, and then by consistently acting in a manner which is in alignment with what has been espoused.

Secondly, there are significant (and largely ignored) ethical issues concerning the legal privileges of incorporation and limited liability. The whole of corporate life ultimately depends on the maintenance of these privileges. Yet, without realising what is at stake, various factors are now eroding a general consensus that made possible the original innovations.

Shareholder activism, for example, has the effect of eroding the barrier that shields shareholders from the full consequences of corporate conduct. This barrier was erected in the 1850s and only after at least half a century of vigorous debate. At that time, the House of Commons in the UK agreed that if shareholders were to enjoy the extraordinary privilege of limited liability, they must not interfere in the day-to-day management of a corporation. Instead, shareholders must allow directors, who bear ultimate responsibility for corporate conduct, to make decisions in the best interests of the corporation (a distinct legal person) as a whole.

It is not just shareholders who have misunderstood their role. The same is true of many directors. In recent years, a number of directors have started to assert that the principal duty of directors is to shareholders – or, more precisely, to increase shareholder wealth. With one exception (a change of control situation), this is simply not true. Directors are bound to act in the interests of the company as a whole, and the company is a separate legal person with interests that are not reducible to those of the shareholders.

Sir John Dunlop, one of the doyens of an earlier generation of Australian company directors, observed that the duty to shareholders, where it exists, is to shareholders in perpetuity, not to a particular group of investors at a particular time. Company directors have long understood that even if a significant majority of shareholders want a dividend to be paid, their duty to the company may require them to withhold the distribution of profits for purposes of reinvestment.

Unfortunately, the proper understanding of a director’s obligation has been watered down by that rhetorical phrase, “duty to shareholders”. One effect of this has been the adoption of dividend policies that are unproductive and ultimately unsustainable. This not only weakens companies – it is also the major restraint on national productivity. As the Productivity Commission has noted – it’s a lack of investment rather than a lack of labour productivity that is hampering the nation. Alas, too few boards have the stomach to act responsibly, risk their board seats and face down shareholders calling for dividends.

It’s time we returned to a true and proper understanding of the fact that shareholders do not “own the company”. They merely own a share of its issued capital – and may exercise the rights attached to each share.

GLC: How do you see the relationship between business ethics and organisational performance?

SL: A few years ago, the Ethics Centre and Beaton Consulting surveyed a large group of people (around 15,000) and found that if there is alignment between what an organisation says its stands for (its purpose, values and principles) and what it actually does, then [employees] will give discretionary effort. When there is no alignment, they will withdraw. In fact, there have been countless studies that have shown that the root of sustained economic prosperity by corporations is to maintain that tight alignment.

This is particularly important in this day and age where strategic effects – the things that make or break a company – are no longer in the hands of the board or the CEO alone. If, for example, an employee does something problematic that is picked up by traditional or new media then it is often the case that the problem is escalated to the CEO and board. That is, anyone – at any level of a corporation – can generate strategic effects.

It has now become clear that you can’t control these risks by relying on rules alone. That is, there are serious problems that come with an over-reliance on compliance.

Boards should define and promote an ethical framework.

Regrettably, fearing personal liability, company directors have become some of the most prolific regulators in the land – creating internal systems of regulation and surveillance that are just as constraining as anything dreamt of by government. I think at the core of good governance is the duty of the board to ensure that individuals within the corporation, and the corporation as a whole, consistently make decisions that are good and right. Grant King, the CEO of Origin Energy, has put it in a disarmingly simple way: corporations that do well make more “good decisions” than “bad decisions”; they do more things that are “right” than “wrong”.

GLC: What can directors and the board do to help facilitate an ethical organisational culture?

SL: Boards should define and promote an ethical framework. The purpose of such a framework is to enable people, when acting on behalf of the corporation, to work from a common understanding of what makes a decision “good” or “bad”, “right” or “wrong”. That is what comes out of specifying values and principles related to a defining purpose.

Boards should ask management to include in board papers, as a matter of course, an account of the ethical issues arising from the organisation’s operations and in relation to the key decisions the board is being asked to make. This would include an analysis of which stakeholders are affected, and how actual and proposed conduct aligns with the organisation’s stated values and principles.

In particular, the board should guard against the development of “unthinking custom and practice”, which is one of the great enemies of ethics. Most major instances of corporate wrongdoing are not the product of deliberately wicked people engaging in deliberately wicked conduct. More often than not, people drift into wrongful conduct and will look back and say: “I didn’t see it at the time”, “because everybody did it”, “because that’s just the way we did things”.

GLC: What approach might a director take if his or her personal ethics conflict with the corporation’s plans or conduct?

SL: What approach might a director take if his or her personal ethics conflict with the corporation’s plans or conduct?

Secondly, I’d ask: “Do my concerns have strategic implications for the company and for the successful operation of the company within its own ethical framework?”

If there is some room for you to raise the issue, I would say: “I think there’s a strategic issue to consider. I have my own personal feelings, but I think it’s a matter we need to look at given the company’s existing ethical framework and its strategic interests.”

If you invoke the company’s own framework, rather than focusing on what you personally feel, then it’s a legitimate thing to do.

If, despite your best efforts, your fellow directors rebuff you and are committed to continue on the current journey, then you may need to resign as a matter of good conscience. If the company really is so completely divorced in its strategic and ethical intent from your own ethical position, then it begs the question of why you joined the board in the first place.

To read the full interview, visit www.companydirectors.com.au/glc. Dr Simon Longstaff AO will be a speaker at the Australian Governance Summit in March.