Shareholder versus stakeholder capitalism

Time to re-evaluate legal responsibilities of directors while considering the UK experience.

A leading law academic, Professor Ian Ramsay of Melbourne Law School, has called for a new debate on whether Australia should follow the United Kingdom’s lead and clarify directors’ duties to consider the interest of stakeholders, beyond shareholders.

Ramsay believes it is time to reconsider section 181 of The Corporations Act 2001 (good faith) and whether it should include corporate social responsibilities or explicit obligations to take account of the interests of certain classes of stakeholders.

“It’s appropriate to give consideration to whether UK changes to recognise a director’s duty to consider stakeholders’ interests would be beneficial here,” says Ramsay. “We need to assess evidence on the impact of the UK change, in effect now for over a decade, and whether the change would work in an Australian context.”

Ramsay’s view is timely. There has been renewed interest this year here and overseas in a longstanding governance debate – shareholder versus stakeholder capitalism. The Financial Services Royal Commission in Australia emphasised that boards should consider the needs of stakeholders such as customers, employees and the community, and not only shareholders.

Proponents of “shareholder capitalism” say a listed company’s objective is to maximise the value of its shares because that is the main interest of its shareholders. Under this model, directors act as agents of shareholders and monitor their interests.

Supporters of “stakeholder capitalism” say companies should consider the interests of groups, including shareholders. In considering the needs of customers, employees and other stakeholders, boards in theory are helping their company maximise its economic objectives. In this model, the goals of stakeholder and shareholder capitalism are compatible.

Governance has moved more towards stakeholder capitalism this decade as industry superannuation funds, sovereign wealth funds and other institutional investors seek to understand the organisation’s approach to Environmental, Social and Governance issues, as part of the board’s broader focus on risk management and organisation sustainability.

This debate has been ongoing for decades and the push between shareholder and stakeholder capitalism has ebbed and flowed. After periods of intense shareholder capitalism, where some companies pursue profit maximisation too aggressively to benefit shareholders, there tends to be greater focus on stakeholder capitalism as organisations consider a wider range of groups.

That may be happening on Australian boards. More directors this year have commented in the Governance Leadership Centre about their board’s efforts to govern for employees, customers and other stakeholders, and to better understand their organisation’s role in the community.

“There have been too many instances this decade where the relentless pursuit of profit maximisation, linked to executive incentives, has been a disaster for shareholders,” says Ramsay. “It has led to excessive risk taking in some organisations, poor sustainability and loss of wealth for shareholders. Clearly, boards must govern beyond only the needs of shareholders.”

Stakeholder capitalism, in theory, makes sense. Doing the right thing by employees, customers and the community – and balancing their needs with organisation profitabiliy – is smart business. Done well, it can make organisations more sustainable and profitable.

But stakeholder capitalism has complications for boards. The term “stakeholder capitalism” is itself ambiguous, given only shareholders contribute economic capital to the organisation. Employees contribute human capital and customers contribute relationship capital and goodwill, but does that entitle them to a stronger voice in the boardroom?

Shareholders elect company directors, yet boards, under the stakeholder capitalism model, are expected to govern for stakeholders who have no voting rights. Practically, is board composition sufficient to understand the needs of such a diverse range of stakeholders, or should they include employee-elected directors, for example, to better understand staff needs?

The main concern is boards embracing stakeholder capitalism to the detriment of shareholders. That is, a focus on governing for employees, customers and suppliers detracts from organisation profitability. Or that shareholders have lower priority in governance decisions.

Commissioner Kenneth Hayne in the Financial Services Royal Commission made his position clear on the need for boards to consider the interests of stakeholders, including shareholders.

Commentary on governance in the Commission’s Final Report said: “The longer the period of reference, the more likely it is that the interests of shareholders, customers, employees and all associated with any corporation will be seen as converging on the corporation’s continued long term financial advantage. And long-term financial advantage will more likely follow if the entity conducts its business according to proper standards, treats its employees well and seeks to provide financial results to shareholders that, in the long run, are better than other investments of broadly similar risk.”

Can Australia learn from the UK approach?

The UK made important changes in 2006 to clarify directors’ duties to stakeholders.

Section 172 (1) of the Companies Act 2006 (UK) provides that a director of a company must act in a 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, and in doing so have regard (among other matters) to:

• The likely consequence of any decision in the long term;
• The interests of the company’s employees;
• The need to foster the company’s business relationships with suppliers, customers and others;
• The impact of the company’s operations on the community and environment;
• The desirability of the company maintaining a reputation for high standards of business conduct; and
• The need to act fairly as between members of the company.

In Australia, section 181 of The Corporations Act says Directors or Officers of a corporation must exercise their powers and discharge their duties:

• In good faith in the best interests of the corporation;
• For a proper purpose.

Ramsay says Australia’s director duties provide scope for directors to focus on the needs of a broader group of stakeholders because it is in the best interests of the corporation. “By and large, Australia has a good set of directors’ duties and courts have interpreted them appropriately to guide boards,” he says. “But there is a case that it’s time to revisit whether section 181 could be strengthened by adding similar wording to section 172 in the UK.”

Ramsay says section 172 clarified the duty of directors to stakeholders and may have led to more informed and balanced governance decisions in this regard, supported by UK law. “At a minimum, we know section 172 has not been disruptive for UK boards,” he says.

Comparisons between the business objectives of the top 100 companies in the UK, Australia and United States show UK boards have greater prioritisation of stakeholder interests.

Ramsay and Belinda Sandonato, a researcher at Melbourne Law School and lawyer at the Australian Securities and Investments Commission, compared the UK experience and published their findings in a 2018 paper in the Companies and Securities Law Journal.

The authors found most companies in the UK, Australia and US prioritise shareholder interests. However, fewer FTSE 100 (UK) companies prioritise shareholders only and UK companies were likelier to prioritise shareholders and consider the interests of named stakeholders.

“This might be the effect of section 172 (1) of the Companies Act 2006 (UK) that requires directors to promote the success of the company for the benefit of shareholders, but in doing so, to have regard to other stakeholders such as employees, customers and suppliers”, they wrote.

Although UK companies have greater regard to the needs of stakeholders, there is no evidence on whether this focus has led to higher long-term returns from FTSE 100 companies. “Business groups in the UK that were initially opposed to the change now support it and have put out proactive guidance to help boards govern for a broader group of stakeholders,” says Ramsay. “They see value in the change and it’s become a regular part of business in the UK.”

Restarting the debate

The Federal Government considered in 2005 whether The Corporations Act should be amended to include corporate social responsibilities through the CAMAC Social Responsibility of Corporations Report and again that year through the Parliamentary Joint Committee on Corporations and Financial Services inquiry into corporate social responsibility. The CAMAC report was published in December 2006 and section 172 of the UK Companies Act was by then legislation.

Both inquiries found no compelling case to amend section 181 in The Corporations Act. CAMAC said the phrase “the best interests of the corporation” obliged directors to act in the best interests of shareholders generally and that they could consider a range of factors external to shareholders if this benefits shareholders as a whole.

The inquiries were held around the UK change in 2006 on director duties, meaning there was limited international experience to draw on. Also, there have been recurring corporate scandals since then as some companies pursued profit maximisation to the detriment of customers – a practice noted in the Financial Services Royal Commission.

“Australia now has more than a decade of the UK’s experience to learn from and much has changed in that period in how investors and communities view the role of corporations,” says Ramsay. “My sense is it’s an appropriate time to revisit this issue in Australia.”

Ramsay believes change to section 181 could protect directors. “The Corporations Act says nothing about what the ‘interest’ of a company is and by and large boards have interpreted this as prioritising shareholder needs. But in some circumstances, such as insolvency, other stakeholders might be a greater priority over shareholders.”

Ramsay adds: “Directors cannot assume that the needs of shareholders always come first or that other stakeholder interests are irrelevant. Well-informed boards ensure that all key stakeholder interests are considered in their decisions. An appropriate change to section 181, based on considered research and debate, would give boards greater legal authority to govern for the interests of a range of key stakeholders, rather than assume that doing so is in the best interests of the corporation.”