Vincenzo Bavoso – draft of November 2013 – forthcoming ICCLR
“The global financial crisis, the pervasive resilience of shareholder value, and the unfulfilled promises of Anglo-American corporate law”
Vincenzo Bavoso[1]
1 Introduction
2 Foundation of shareholder value in the UK and the US: business ethos and theoretical construction
3 The normative and judicial base of shareholder value in the UK and the US
4 How shareholder value redefined corporate governance practices
5 Critical reflections and conclusions
Abstract
The paper provides a review of the theoretical, normative and judicial base of the shareholder value paradigm in order to assess its ultimate justification both in the UK and the US. It further critically reflects on the extent to which shareholder value has shaped the direction of corporate strategies in a mono-dimensional way beyond having failed to provide sound mechanisms of control in large public firms.
1 Introduction
Much of the academic debate in the wake of the global financial crisis (GFC) has focused on issues of financial regulation. Questions related to the overall sustainability of the corporate governance system however have also been triggered post-2008, for two main reasons: firstly, because the GFC has reignited concerns that had already surfaced a decade ago with the North American corporate frauds, and which today present more urgent regulatory challenges due to the externalities that large public corporations create on different societal constituencies; secondly, because in the past more specific legal issues related to the corporate objective of financial institutions had probably been neglected.
Corporate law debates today are dominated by the broad question of the corporate objective[2], which flows into the classic dichotomy between shareholder value and stakeholder theory. While the paper does not purport to provide a comparative discussion on these theoretical frameworks, it seeks to assess the foundation of shareholder value in the main jurisdictions where it finds application, the UK and the US, and its influence on corporate strategies. The analysis’ relevance rests on two main underlying issues. Firstly, shareholder value has translated into dubious corporate governance mechanisms (chiefly stock options and the market for corporate control) designed to create boards’ accountability in large public firms. Secondly, the ensuing decision-making dynamics have failed to adequately incorporate goals beyond the maximisation of shareholders wealth.
The undisputed axiom of shareholder primacy has resiliently survived through a number of corporate scandals and crises over the past fifteen years and it still remains the paradigm of corporate management. This leaves the above questions open, firstly because liability rules and systems of accountability have remained functional to pursuing strategies directed at maximising share price on the part of management, and secondly because corporate decision-making under shareholder value is not sufficiently geared to the interests of different stakeholders.
The paper ultimately provides an overview of the theoretical, legal and judicial foundation of shareholder value, and it critically reflects on the way it has shaped both corporate strategies and mechanisms of control, which have arguably been the main corporate law pitfall during the GFC. It is structured as follows: section two defines the foundations of shareholder value through its theoretical underpinnings; section three highlights the legal justification and prevailing courts’ orientation to the question of the corporate objective. This leads to a more critical assessment in section four of legal strategies designed to direct managerial behaviour, which arguably have remained aligned to a mono-dimensional corporate governance objective. Section five concludes and offers some critical reflections.
2 Foundation of shareholder value in the UK and the US: business ethos and theoretical constructions
This section provides a brief overview of the arguments that have propelled the application of shareholder value paradigms in the UK and the US.
Shareholder value emerged in the 1980s as the guiding principle of corporate management, chiefly due to the influence of financial-economic theories flowing from the strong Neo-liberal consensus.[3] The roots of this ethos however are closely related to the much earlier phenomenon of the separation of ownership and control in large public corporations, firstly recognised by Berle and Means in the 1930s in the US.[4] Ownership dispersion and the resulting agency problem[5] owed to the delegation of managerial powers to the board of directors (recognised as the separation of ownership from control[6]) triggered the necessity to find an institutional model of corporate governance suitable to direct decision-making processes within large public corporations.
From a business perspective, shareholder value represented both in the UK and the US a managerial justification to prioritise the returns of equity-holders ahead of different interests of consumers, employees and creditors.[7] This has become more evident in the last twenty years with the increasing centrality of capital markets’ logics on the mechanics of corporate behaviour – a phenomenon broadly referred to as “financialisation”.[8] This led to a much deeper redefinition of managerial objectives because firms were found to be increasingly competing for high returns to meet investors’ demands.[9] Deep and liquid stock markets were indeed the catalyst for the application of the shareholder value doctrine, because, according to “agency theorists”, they provided the competitive mechanism to address problems related to the separation of ownership and control.[10] This happened through firms’ competition for the price of financial stock and through competition for the managerial labour market.[11] Similarly, the reliance on market-based information represented under shareholder value the necessary monitoring tool for security-holders in the absence of more direct systems of control. Confidence in market mechanisms was also reflected in the belief that share prices represented a valid signal of the relevant information related to income-generating potential of a corporate investment, which embodied a straightforward application of the Efficient Market Hypothesis in corporate law.[12]
Despite underpinning chiefly from American scholarship, the theoretical assumptions that have accompanied the application of shareholder value present a high degree of acceptance across the Atlantic. These have revolved around the “contractarian” view of the firm developed in the US in the 1970s that identified the company as a “nexus of contracts” entered into by different parties inter se, with shareholders retaining the role of residual claimants.[13] This in turn led to the rhetoric of ownership advocated by economic scholars, postulating that public corporations belong to their shareholders because of the risk they bear.[14]
Secondly, the afore-mentioned interplay of large public firms with financial markets strengthened the belief that share prices are a good measure of firms’ value.[15] The expansion and globalisation of liberalised capital markets accentuated the process of creation and distribution of value from financial assets. This increased shareholders’ expectations that in turn pushed management to pursue short-term gains.[16]
Thirdly, shareholder value was also seen as creating a better system of accountability through its single metric – the share price. It was suggested that without this parameter, the management would not be accountable towards any stakeholders, increasing therefore agency costs.[17] It was also argued that from an efficiency perspective directors are better suited to focus on one identified objective – maximising shareholders wealth – rather than attempting to fulfil diverging interests of more constituencies.[18]
Fourthly, it was assumed that managers and directors should be compensated in a way that keeps their interests aligned to shareholders. To this extent, stock options were thought to serve the purpose of creating incentives for executives to maximise share value and pursue strategies that favour their personal interests as well as shareholders.[19]
Lastly, as anticipated above, financial markets were devolved a fundamental disciplining role under the shareholder value paradigm. Market discipline was believed to be achieved through an active market for corporate control (hostile takeovers), which was thought to represent a threat for underperforming boards and an ideal allocation of corporate resources.[20]
Against the backdrop of these theoretical constructions centred on the primacy of shareholders as managerial goal, their effective power to challenge the day-to-day running of the company has remained limited both in the UK and even more so in the US.[21] This suggests that shareholder value on both sides of the Atlantic has resulted in an organisational model of corporate law based on business practices, supported by economic theories of the firm, and fuelled by increasing pressures from financial markets.[22] However, as will be discussed in the next section, this organisational framework is not also reflected in legal mechanisms that allow stockholders to validate their position as the beneficiaries of corporate management.
The above statement reiterates some of the problems stressed by Berle and Means in the 1930s, concerning the self-perpetuating power of managers within a legal environment that did not provide effective mechanisms of accountability and control.[23] One question then that has emerged more recently in the context of the recent wave of banking crises would be whether it is shareholder value that is envisaged as corporate goal, or rather managerial value.
3 The normative and judicial base of shareholder value in the UK and US
What was stated at the end of the previous section leads to the necessity of briefly exploring the normative base of shareholder value in the UK and the US and then assess how courts have approached the fundamental question of in whose interest corporations should be run.
Despite a relative theoretical convergence, the legal foundation of shareholder value differs fundamentally across the UK and the US. In the UK, shareholders wealth maximisation has been essentially endorsed at statute level in the Companies Act 2006, with the controversial development of s.172 where directors are deemed to act in the interest of the company (as per s.170 that clearly states that duties are owed to the company) which however coincides with the interests of its members who remain the only constituency that can bring a derivative action for a breach of duty.[24] While s.172 did provide a list of constituencies beyond shareholders that should benefit from the corporation’s activity, shareholders retain among them a position of priority which is most importantly exemplified by the fact that under UK law directors are accountable only to shareholders as long as the company is a going concern.[25]
Similarly, in the context of takeover bids, UK company law endorses a very clear stance on shareholders retaining a central position in determining whether the bid succeeds or fails. The law prohibits directors from acting in a way that frustrates the bid[26] and more specifically directors’ duties in the context of takeover bids clearly shift from being owed to the company, to being owed to shareholders.[27]
Finally, it is worth pointing out another aspect of the UK legal regime that makes it an ideal playground for shareholders in public corporations. Five percent voting right is in fact sufficient to call a meeting[28] and exert pressure on the board to distribute dividends (provided of course profits are available as per s.830 CA 2006); this is coupled with the relative ease with which directors can be removed through ordinary board resolution (under s.168), which in turn entails that UK companies tend to be generous with dividends, unlike their American counterparts, as will be discussed later.
In the US, shareholder primacy is not a legal requirement, but it remains an ideology, which is applied to address practical necessities of business life.[29] The absence of a normative reference – both at federal level[30] and in Delaware (the jurisdiction where most US public firms are incorporated) – leaves some ambivalence as to the role of shareholders in corporate governance.[31] The Delaware statute does not provide any clarification on the issue of corporate purpose beyond stating more generally that corporations can be formed to conduct or promote any lawful business or purposes.[32] Other states’ corporate statutes go as far as excluding shareholder primacy by stating that directors may serve the interests of other constituencies too, like employees, creditors or the local community.[33]
From a different perspective, directors’ liability is governed chiefly by the “business judgment rule”[34] which affords directors a great degree of discretion because the due care in their decision-making is only attached to the underlying process. Essentially, as long as directors’ actions are not affected by conflicts of interests and as long as they have made reasonable efforts to be adequately informed, courts will not second-guess the board’s wisdom as to what is best for the company even if that is not aligned with shareholders’ best interest.[35] Thus, as shareholder primacy is not embedded in the law[36], the board is effectively free to forsake shareholder value in the running of the company. This is only countered to an extent by a relatively easier and broader access that shareholders have to derivative actions, compared to the UK legal scenario, even though procedural burdens remain high and sometimes difficult to overcome.[37]
The lack of shareholder-centred regulation in the US is emblematic in the context of takeovers, where, as stated in the Delaware case between Air Products Inc v. Airgas Inc[38], directors are permitted to consider other stakeholders’ interests and employ a number of strategies and defences in order to frustrate the bid.[39]
Finally, unlike their UK counterparts, US shareholders have more difficulty in removing directors because according to Delaware law this would need to be substantiated by a cause.[40] Moreover, shareholders have no default powers to call a meeting and the general expectations to receive dividends in US public companies are not high, as will be illustrated later in the context of the recent Apple bond issue.
Having looked at the theoretical foundation of shareholder value and at its basic normative framework in the UK and the US, it is worth exploring the judicial orientation of courts across the Atlantic and assess whether they have provided any clarifications on the issue of the corporate objective and more specifically on the meaning of “interest of the company”.
In the UK, courts have traditionally followed, even before the 2006 codification, the orientation whereby the “interest of the company” (in s.172 Companies Act 2006 this is expressed as “success of the company”) represented the ultimate objective and what binds directors to their duty. The more specific identification of “interest of the company” and of what constituency should be intended as beneficiary of the corporate success has however remained blurred. In other words, while the Company Law Review Steering Group operated during the reform process under the assumption that the interest of the company would normally coincide with the interest of its members, the shareholders[41], this does not entirely reflect what courts have suggested.[42]
An early interpretation was provided in 1878 in Re Wincham Shipbuilding where the question as to for whom directors are trustees (later to become a central academic debate in the US between A. Berle and M. Dodd and then further developed in the UK by L. Sealy) was addressed by stating that “directors are trustees for the shareholders, that is for the company”.[43] This early and relatively clear direction was followed by what is generally regarded as the central authority pointing towards shareholder value, the case of Hutton v. West Cork Railway Co.[44] The case concerned the power of the board to make payments to employees after the company had ceased to be a going concern. While the judgment is often cited for the famous statement that “the law does not say that there are to be no cakes and ale, but there are to be no cakes and ale except such as are required for the benefit of the company”, what the court really reiterated was that the test to judge directors’ decision was whether the money that was being spent was functional and incidental to the carrying on of the business of the company.[45] In stressing the centrality of the benefit of the company as a whole, the Court of Appeal did not specify whether shareholders were to be intended as recipients of that interest.[46]
Later cases have not contributed to clarifying the above open question. In Greenhalgh v. Arderne Cinemas, a case that dealt with alteration of the articles of association and hence only partly relevant, the judgment made reference again to the interest of the company as a whole, which was meant to encompass the corporation as a general body rather than a commercial entity.[47] In Parke v. Daily News Ltd, a case presenting a more specific context of directors’ duties, where the money received from the sale of part of the moribund business was proposed to be devoted to the employees as benefit, the court defined interest of the company as benefit for the shareholders as a general body.[48] While this orientation was confirmed in Brady v. Brady[49], other more recent cases questioned the validity of the shareholder paradigm. In Lonrho Ltd v. Shell Petroleum Co Ltd, Lord Diplock stated that it was a duty of the board to evaluate whether allowing an inspection of documents would be in the best interest of the company, and this had to be recognised not exclusively in its shareholders but in its creditors too.[50] Similarly, the Court of Appeal in Fulham Football Club Ltd v. Cabra Estates Plc stated that directors’ duties are owed to the company which is not identified only with the sum of its members.[51]