Thinking the Unthinkable

Tuesday, 27 February 2018

Dr Simon Longstaff AO photo
Dr Simon Longstaff AO
Executive Director, The Ethics Centre

    Amid the debate over social licence to operate, company directors need to find new ways to sit “on the same side of the table” as the people — or they risk losing their legitimacy, warns Simon Longstaff AO.

    Across the world there has been a precipitous decline in public trust in institutions — including corporations. This has reached a far more serious phase in which the legitimacy of the entire system has been opened to question. The “unthinkable” is now under active discussion.

    For example, the UK Government’s green paper on corporate governance specifically raises the question of limited liability as a privilege that risks being abused. In response to the green paper, the influential Institute of Business Ethics submitted that: “We agree that reform should bring unlisted companies into the net. In this context we are struck by the reference to the ‘privilege’ of limited liability... Limited liability should not be an inalienable right, but one earned by recognition of responsibility. In cases of really egregious behaviour, it should be possible to remove this right.”

    So, the nation that brought the world the legal privilege of limited liability (a cornerstone of corporate architecture globally) is now actively debating whether or not that privilege should be abridged or rescinded in cases of serious corporate wrongdoing. How has it come to this?

    Purpose of the corporation

    Modern corporations were only established in the mid-19th century. Previously, they had been formed by the express permission of either the British Crown or Parliament. In fact, for the 100 years prior to 1825, the formation of a joint-stock company had been illegal — and an indictable offence.

    However, inspired by the arguments of the Scottish moral philosopher Adam Smith, and by the political temper of the times (after more than 50 years of contentious debate), the British House of Commons eventually decided to enact separately (and then in one consolidated act) legislation that:

    • allowed a corporation to be formed by the simple act of registration; and
    • accorded to investors the extraordinary legal privilege of limited liability.

    The first of these innovations allowed for the creation of a legal (non-natural) individual person. Potentially “immortal”, this person had an identity distinct from any other person, including stockholders, directors and employees. Indeed, corporations are the owners of their assets (not their shareholders) and enter into contracts and other agreements entirely on their own account. All corporations have an obligation to maintain their essential viability — thus the need for commercial corporations to secure capital, attract employees, build essential relationships and do all the other things necessary to be sustainably profitable.

    The second innovation created a remarkable legal privilege in which stockholders might enjoy unlimited “upside” in terms of capital gains and dividends, but be liable for no more than the unpaid capital associated with the percentage of issued stock for which they had subscribed. If a person had subscribed just £1 of capital, that would be the extent of their liability, irrespective of any harm done by the company. In return, stockholders would not exercise direct control over the corporation, leaving that to directors they might occasionally elect.

    These decisions were highly controversial and only made after overcoming the objections of many who felt that the severance of bonds of personal responsibility would increase the risk of harm to individuals and society. Indeed, in 1844, a report of a select committee enquiring into the provisions of the Joint Stock Companies Bill (enacted later that year) had used headings such as “Form and Destination of the Plunder”, “Circumstances of the Victims” and “Impunity of the Offenders”.

    The contrary argument was that the combination of easy incorporation and limited liability would ultimately increase the stock of common good. The “particular” good to be achieved concerned the relative ease of suing a corporation (as a distinct legal person) as opposed to having to sue each of the separate members of earlier “commercial collectives”. The “general” good was that increased economic activity (based on diminished personal risk) and an expression of personal liberty (to form associations) would be good for society as a whole. Adam Smith believed the “market” was merely a means to an end. Of no intrinsic value, a truly free market would improve the conditions of all.

    In arguing the case for easy incorporation and limited liability, one of the greatest champions of reform, Robert Lowe MP (and vice-president of the Board of Trade), made the explicit point (during the 1856 consolidation debate) when asking, “Who could have imagined it possible that a state of society resting on the most unlimited and unfettered liberty of action, where everything may be supposed to be subject to free will and arbitrary discretion, would tend more to the prosperity and happiness of man than the most matured decrees of senates and of States? These are the wonders of the science of political economy and we should do well to profit by the lesson which that science has taught.”

    So, from the beginning, the purpose of the corporation per se was to advance the “prosperity and happiness of man”. As a creation of society, the corporation was never intended to provide an exclusive (or dominant) benefit to shareholders. That is, a limited focus on increasing shareholder wealth is not a purpose of the corporation.

    Although statute and common law has evolved since the 1850s, the general purpose of the corporation has not changed.

    The threat to limited liability

    Whether or not the privilege of limited liability should be maintained in all circumstances is now becoming a genuinely open question. The proposal that the state pierce the “corporate veil” and wind back (if not eliminate) the privilege of limited liability is not entirely novel. For example, the Australian National University’s Professor John Braithwaite has argued for the “capital punishment” of corporations. If found guilty of some crimes, they would effectively be “confiscated” by the state — to the ultimate detriment of owners and investors.

    In an interview with Corporate Crime Reporter in 2014, Prof Braithwaite said, “The main hope is in the ethical cultures of corporations. The criminal law has a big role to play in constituting that ethical culture. But the idea of the regulatory pyramid is that you want most compliance with the law to be driven by internal compliance systems. But internal compliance systems won’t work if there are no consequences for not taking internal compliance systems and corporate ethical cultures seriously.

    I’m a great believer in not only criminal punishment, but in corporate capital punishment as well... take the organisation over and have the government run it.

    “You need that escalation up the pyramid. The deterrence penalties become greater and greater as you move up the pyramid. And at the tip of the pyramid, you have corporate capital punishment. You take the organisation over and have the government run it, or there is a forced sale of the corporation to an ethical management team.”

    Prof Braithwaite then added, “I’m a great believer in not only [corporate] criminal punishment, but in corporate capital punishment as well.”

    The difference today is that such proposals resonate with a much wider body of public opinion. The reason for this is that, in political conditions of mounting populism, democratic governments are being pushed to adopt increasingly severe measures to allay the concerns of a general public that feels that “the system” and its “elites” have failed to meet their obligations and “increase the stock of common good”. Indeed, a certain brand of populism claims that the entire system has enriched the few at the expense of the many. Thus, the political inclination to elect outsiders who will purge the system.

    Implications for company directors

    Although I have never seen it expressed in these terms, it seems that it is at least arguable that company directors have an implied fiduciary duty, to shareholders, to govern the corporation in a manner that does not give rise to the risk that society might remove or mediate the privilege of limited liability on which their shareholders so heavily rely.

    This means that directors need to do far more than ensure a company has a “social licence to operate”. This is a transactional model in which society secures a tariff (the “licence fee”) in return for hosting what might be otherwise unwanted corporate operators. This is a perilous foundation on which to build — and far too “transactional” than what is required to manage the kind of political threat outlined above.

    Company directors need to start repositioning the corporations they govern as integrated parts of civil society, and to find new ways to sit “on the same side of the table” as the people. This is not about transactions — but relationships. Privileges like limited liability are best protected by popular consent — not by the assumption that they’re mandated by history and protected by an (increasingly impotent) political class.

    It may be a relatively old idea; however, 30 years ago, Sir John Dunlop observed the following: “I put it to you that the directors are responsible to the shareholders for profit in perpetuity; and that this general expression of a principle permits, indeed requires, directors to pay full regard to their employees, to labour relations generally, to the community, to the country, in all their decisions for and on behalf of shareholders.”

    It’s advice that should be heeded today — lest the unthinkable actually becomes real.

    UK green paper recommendations

    Last August, the UK Government published its response to the green paper on corporate governance reform, with changes introduced to apply to UK-incorporated companies for the accounting period from June 2018. The reforms cover three main areas:

    1. Executive pay. Mandatory disclosure in directors’ remuneration report of the ratio of CEO pay to the average pay of the company’s UK workforce, plus how it relates to pay and conditions across the wider workforce; clearer disclosure of share-based incentive components of remuneration policies and increasing the vesting and holding periods for share-based remuneration.
    2. Greater stakeholder input at board level. Mandatory disclosure of how boards have regard to non-shareholder interests, adoption by the board of an employee engagement mechanism and informal guidance in relation to employee and other stakeholder engagement.
    3. Corporate governance in large privately owned companies. A new corporate governance code for large private companies and mandatory disclosure by such companies of their governance arrangements.

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