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Applied corporate governance:

The purpose of a company - two competing conceptions

by Simon Longstaff

A minimalist view

Until recently, the most conventional response to a question about the purpose of a company was a paraphrase of Milton Friedman along the lines that the purpose of the company was to generate the best possible return on the investment of shareholders.

Based on a variation of Adam Smith's argument concerning the benefits that can flow from the unadulterated pursuit of self interest, it has been argued that a single minded pursuit of profits will, in the long run, ensure that market signals will be properly attended to by the company. As such, the company will aim to produce goods and/or services at the lowest possible cost and then sell these at the highest possible price to the greatest number of purchasers.

To put the purpose of a company in these terms is, of course, to engage in a form of caricature. Life is never quite so simple. But for many theorists the 'wrinkles' in the theory are few and far between.

For example, issues of the kind raised by people concerned about the social responsibility of business are dealt with by arguing that a rational concern for profitability will ensure that all costs are minimised and all opportunities maximised. Therefore, a rational company will maintain a general level of good standing with investors and consumers by avoiding doing anything likely to harm its image in the eyes of these groups.

In a similar vein, such a company will ensure that it avoids the payment of fines (and other penalties) for breaches of regulation and the law and so on. In other words, such a company will go about its business in a fashion that is limited only by a set of side-constraints imposed by the market or in the form of legally and sanctionable laws and regulations.

The performance of directors of this kind of company will, on this view of the world, be judged ultimately in terms of their capacity to generate superior returns for their investors. All other considerations will be subsidiary.

For example, a concern to minimise damage to the environment or to foster the development of a humane working environment in which people flourish will only be of significance to the extent that it contributes to the bottom line.

Of course, even this characterisation of the board's responsibility is plagued by the vexing question concerning the identity of the shareholders whose interests are supposed to be best served. The practical reality for most boards – and especially those with active institutional investors – is that the current crop of shareholders demand that their interests are supreme. Yet, again, matters are not so simple.

For example, it has been persuasively argued that if the directors' duty is to shareholders, then it is to shareholders in perpetuity. Indeed, this follows clearly from the fact that a corporation, as a legal person, is theoretically immortal. Since its natural-person shareholders are all too mortal, it would be unjust of directors to act in ways that deliberately advantage one class of shareholders (the current group) at the expense of others who might hold those same shares at another time.

The implications of this are put quite succinctly by one of the doyens of an earlier generation of Australian company directors, Sir John Dunlop, who observed:

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.

Even so, the original conception of the role of the company (and hence its directors) as I have been describing it above, is left intact. For directors, acting qua directors, all concerns – other than to shareholders – are subsidiary.

As noted above, my presentation of this model is overly simplistic. Very few directors would see their companies quite in the terms I have outlined. Instead, they would recognise that, as a bare minimum, the fact that they (and their companies) exist in society generates a number of additional obligations – many of which are expressed in the law of the land.

Indeed, they may very well recognise that they have duties, as citizens, to uphold the law – even if to do so would not be in the interest of shareholders – let alone the company as a whole. Even so, the thing to note is that, unless such laws apply to directors qua directors, any concern about broader community standards may be external to the role of director unless they impinge upon the profitability of the company.

Discussion of community leads to an alternative perspective on the role of the company.

A broader view

As noted above, modern corporations are non-natural persons. That is, they are artificial entities. No law of nature nor of man requires that they exist – let alone in the form that predominates in liberal-democratic capitalist societies.

Yet, for all that, we might justifiably consider the joint-stock, limited liability company to be one of the canniest inventions of humankind.

Although there will be some who have radical objections to the consequences that have flowed from the invention of these entities, most will probably agree that the material benefits flowing from the liberation and consolidation of individual capital have been nothing short of staggering. And so it should have been. Otherwise, how would we ever explain the extraordinary privileges accorded, by society, to investors?

Few people think of the issue in this way, so it might be worth spending a moment or two exploring this point. Imagine that a person who outlines his need for a new structure of legal privileges approaches you.

Put simply, he wants you to agree to an arrangement under which he is allowed to make an investment, which could, in principle, generate for him an unlimited ‘upside’.

Indeed, even a modest investment could, over time, net him a fortune. On the other hand, if things go badly, he wants you to agree that his losses be limited to the extent of his investment. No matter how much is owed to creditors, no matter what is done by the company in which he has invested, he wants his liability strictly limited to that investment. If you agree, he says, then this opportunity should be made available to anyone with money to invest – and on the same terms.

As we all know, this is the basic structure under which most companies operate. Now, the ability to have unlimited 'upside' matched by a limited 'downside' is, when you think about it, a pretty amazing legal privilege. So why would any rational community create the corporate veil which, in reality, only a few might enjoy?

There can only be one answer. A rational community would only make such a decision on the basis that to do so would be in the interests of the community as a whole. Or, to put it another way, it would be an act of folly to institute arrangements of a kind that were reasonably believed to lead to a situation in which society, as a whole, was to be worse off.

It is thus that the most basic form of a 'licence to operate' is constructed. There are, as we all know, a plethora of rules and regulations that further constrain what a corporation might do (or not do). These two form part of the formal 'licence to operate' that governs the work of corporations.

However, all of these formal requirements are underpinned by the fundamental notion that companies (and by extension, the world of corporations) should do nothing that will, in its considered opinion, reduce the community's overall quality of life.

This model still leaves plenty of room for the traditional pursuit of profits and an increase in the wealth of shareholders. Indeed, if it did not, then the whole model would, in the end, be self-defeating. Yet, it makes it clear that the duty to shareholders needs to be considered in the context of a wider obligation to society as a whole.

This is not because to do so is ultimately in the interests of shareholders in perpetuity, nor is it in deference to the dictates of the law (which may in any case, vary from time to time). Rather it takes seriously the idea of an obligation to the community in and of itself – because this is part of the bargain on which the whole corporate structure depends.

Seen in this light, corporations are vital parts of the community. They 'come in from the cold' and escape any suspicion that they are merely necessary evils required in the service of the 'invisible hand' of the market.

As this analysis might suggest, the broadening of concerns to include something more than the interests of shareholders has implications for any assessment of the performance of boards. Under this model, the very least that might be required as an additional skillset is an ability to develop a more critical and strategic view of how the company's operations impinge on its stakeholders and the wider society(s) of which it is a part.

One should not make too much of the differences that the alternative understanding of the role of the corporation might have. As we will see, there is a considerable amount that is shared. Having said that, one should also avoid making too little of the distinction.

For example, a minimalist is likely to hold that, all things being equal, the company should spend as little as possible on say, the environment. In other words, meet only the strict requirements of the law.

On the other hand, those persuaded by the broader perspective might require a company to balance the need to generate profits (and therefore be successful when competing in the market for capital) against the need to exceed the minimum legal requirements – for the sake of the community at large.

The arguments against this broader view have been rigorously articulated by a number of theoreticians amongst whom one of the most notable is, as I have mentioned, Milton Friedman.

They entirely reject any expanded notion of the social responsibility of business. Instead, they look to government to secure public goods – either by its own exertions or through the operation of legislation and regulation.

There are many lines to this argument and the kind of response that it deserves. And this is not the place to rehearse them – except to note that one of the by-products of this approach is a relative inability to argue a strong case for the self-regulation of business. This inability is not merely coincidental. Rather, it is a direct product of an approach that sees the limitations to business practices set at a bare legal minimum – always imposed by somebody outside the body of the company.

To my mind, this is a significant weakness in that self-regulation is not only more efficient and effective than state regulation but it also breeds a capacity to exercise responsible and informed judgement that is otherwise allowed to atrophy for want of use.

Conclusion

Any discussion of the performance of boards needs to start with a proper understanding of the purpose of the board, in general and as it relates to the interests of particular corporations. Another way of putting this is to ask, “What is the question to which the board is the best possible answer?".

The answer to that question depends, to a significant degree, on our views of the purpose for which a company exists.

I have attempted to outline two alternative conceptions of the role of the company and, in doing so, to indicate how these differing conceptions might shape our expectations of directors.

As will have been obvious, each conception involves a significant degree of overlap – especially when the view expressed by Sir John Dunlop is taken into account. That is, we might reasonably expect that directors will have a broad strategic interest in how the company that they serve interacts with a broad range of stakeholders.

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