Stakeholders Moving To N-Dimensional Space Anglo Saxon vs. European Model of Corporate Governance

Human Resource Development and customer-centric behavior

have become modern managements’ article of faith. It is for

the corporate governance theory to change itself to keep pace

with the practice. In short, it is moving from the linear thinking

of about shareholder value to the n-dimensional space that

includes everyone

1. The Anglo-Saxon system is typical for countries such

as UK, USA and Australia and is also known as the

shareholder system. Large and liquid stock markets, low

concentration of ownership, one-tier board of directors,

and relatively high level of protection for minority

shareholders and dominant role of institutional

investors are basic characteristics of the Anglo-Saxon

corporate governance system. Management is not

controlled nor supervised by any of the corporation’s

stakeholder groups except the shareholders. The stock

market and investors through the Board exert control

over the management.¹

The Anglo-American model of

the firm emphasizes shareholder value as the only or

last purpose of the firm to which the other (stakeholder)

purposes are instrumental or, at least, functional. The

European model of the firm emphasizes that the firm is

a multi-purpose institution in which shareholder value

plays the central but not the only role. Labor as the most

important stakeholder group besides the shareholders

should be represented and have a right to participate in

the decision-making on the level of the second board,

i.e. the advisory board in the two-tier-board system.²

2. Hampel Committee was categorical in upholding the

primacy of shareholders’ interests on grounds of

expediency. It goes on to say that the directors as a

board are responsible for relations with stakeholders;

but they are accountable to the shareholders. This is

not simply a technical point. From a practical point

of view to redefine the directors’ responsibilities in

terms of the stakeholders would mean identifying

all the various stakeholder groups; and deciding the

nature and extent of the directors’ responsibility to

each. The result would be that the directors would not

be effectively accountable to anyone since there would

be no clear yardstick for judging their performance. This

is a recipe neither for good governance nor for corporate

success.³

Supremacy of Shareowners’ interest?

3. Another argument for maximizing shareholders’ value

is premised on the notion that the owners risk their

investment capital and are the sole residual claimants,

while other parties (e.g. employees) are compensated

on the basis of their marginal products (i.e. paid wages

by competitive labor markets).⁴ Similarly, debtholders

are compensated by way of interest and suppliers get

paid for what they deliver. If they are not happy with

the way a corporation is run, they can simply shift to

any other corporation. Many writers do concede that it

is wise to cater to the interests of the stakeholders such

as employees in enlightened self-interest but they don’t

concede their legitimate claim on the way a company is

run. When Robert Owen raised the demand for a ten-hour

day in 1810, and instituted it in his socialist enterprise

at New Lanark and when he had formulated the goal of

the eight-hour day and coined the slogan: “Eight hours

labor, Eight hours recreation, Eight hours rest”⁵, he was

only acting from higher moral and religious principles

and there was no reference of employees’ fundamental

right to have a say in the way a company is run. The

incredulity of Robert Owen’s contemporaries on seeing

him successful instead of being ruined has not ceased

even today. The notion that shareowner interest should

dominate those of all other corporate constituents

is inconsistent with observed behavior of successful

firms.⁶

4. The debate started with employee representation on the

Board but it is no longer limited to employees. The primary

focus of regulators is still on employees when they

talk of stakeholders. G20-OECD Principles of Corporate

Governance have introduced a separate principle to

accommodate the role of stakeholders in corporate

governance. The modern thinking on the subject has

expanded the ambit to include all the stakeholders i.e.

not only employees but also debt providers, suppliers,

customers, community, and governments. Inclusion

of stakeholders in corporate governance theory is

still not mainstream, yet paradoxically much of the

focus among professional managers is on Customer

Relationship Management (CRM), Intangible Assets,

Supply Chain Management, Balanced Scorecards and

so on rest explicitly on the proposition that corporation

is a network of interdependent people, organizations

and interests⁷. The new management thinking gives

much importance to Human Resource Development,

collaboration with the suppliers and their development.

Corporations go great length in investing in technical

capabilities of their employees and suppliers as their

performance directly affects the corporation. From

the point of view of employees and the suppliers, the

relationship ceases to be purely transactional and

contractual. Their investment of time and money

in firm specific skills ties them down with the

corporation for years. It is not correct to say that if

they don’t like the way the corporation is run they can

simply walk away and enter into new contracts. If they

had no assurance that their interests and viewpoint

will be taken into account they would not agree

for any investment for long term up gradation. In

the modern times even customers are tied down to

the corporations for a much longer time. An obvious

example is buying a computer operating system. It is

not easy to simply change the operating system as all

the downstream applications are built on the original

operating system. Any customer who feels that the

corporation is not likely to take their interests into

consideration while taking decisions will not buy that

company’s operating system.

5. Another argument put forward by those who advocate

supremacy of shareowners’ interest is about an

overall alignment of interests. It is argued that if

the company does well, the employees will also get

more compensation and their jobs will be secure. The

suppliers will have an assured business, community

will have jobs, debt providers will have assurance

of their debts being repaid and as the marginal costs

come down, the customers will have long-term supplies

at a lower cost. Let us begin by examining the case

of debtholders. Their case seems to be simplest as

no complex socio-psychological factors are involved.

Are the interests of debtholders and equity holders

really aligned perfectly? The perception of risk

for the two sets is completely different. Debtholders

are satisfied with a level of risk that just turns in

some profit, as they will receive assured returns at

least possible risk. On the other hand, the equity

holders might prefer a much higher level of risk, as

they will like to take the company to an exponential

growth path even at some risk of failure. Similarly, a

company’s policy of outsourcing or recruiting outside

the local community might put the interests of the

shareowners and the community at considerable

variance. Communities may like the company to spend

considerable sums on CSR whereas shareowners

might like to minimize it to the bare minimum. An

anecdote narrated by a senior consultant is worth

recounting. In the early nineties, Tata Steel appeared

to be in terminal decline. Consultants were called.

They found that the company was spending way too

much on maintaining hospitals and the Jamshedpur

township when the need was to conserve capital.

JJ Irani, instead of cutting down the costs on community,

fired the consultants and motivated employees to

turn around the ailing company. A better-documented

story relates to a meeting that JJ Irani was to

attend on downsizing the workforce. Instead of

downsizing, he gave lifetime guarantee for employment

not only to workers but to their children too. The

decision was overall financially beneficial and the

workforce reduced within ten years from 78000 to

47000 due to natural attrition. In 1914, Henry Ford’s

decision to double the wages while reducing the shift

timings appeared to be crazy but was enormously

successful not only in retaining workers but creating

demand for cars in the working classes.⁸ A narrower

view taken strictly in the interest of maximizing

shareholder value would have been disastrous for these

companies. We can conclude that mindless pursuit of

narrowly defined shareholders’ interests is neither in

the interest of the company nor does it embrace the

interests of stakeholders.

G20 OECD Principles of Corporate

Governance – Principle IV - The Role of

Stakeholders

6. The G20 OECD Principles look at the role of stakeholders

from various perspectives:

1. Employee Union Perspective
   

   The rights of stakeholders that are established

   by law or through mutual agreements are to be

   respected and they should have opportunity to

   obtain effective redress for violation of their rights.

   On the face of it, it might be doubted as to what value

   the principle is adding when some rights have already

   been established by law or mutual agreement. It

   is an issue of the mindset of the Boards and the

   senior managers. Even where law establishes

   rights, there can be a tendency to deny and litigate

   to the bitter end even at a financial loss as not

   yielding to ‘unreasonable’ demands of employees

   might appear as a matter of principle. This kind of

   false principle can be met only with the strength of

   an internationally acceptable principle.
   
   Mechanisms for employee participation should

   be permitted to develop. The import of this is

   not immediately clear unless one looks at OECD

   Methodology for Assessment. It means that

   stock ownership plans and other profit sharing

   mechanisms. It also concerns the Pension

   Plans where the fund is run by employer-controlled

   trusts. The principles require that the trust should

   not be required to obtain consent of the company

   to vote.

2. Creditors’ Perspective
   

   The corporate governance framework should be

   complemented by an effective, efficient insolvency

   framework and by effective enforcement of creditor

   rights. This principle is something that is primarily

   for the governments to implement. A good insolvency

   framework where the residual value in a defaulted

   bond can be quickly realized goes a long way in

   reducing the cost and increasing the availability of

   capital.

3. Information Perspective
   

   Where stakeholders participate in the corporate

   governance process, they should have access to

   relevant, sufficient and reliable information on a

   timely and regular basis. This principle is in tune

   with the disclosure-based regime that is followed

   by almost all modern securities market regulators.

   On the face of it, given the easy availability of

   electronic dissemination, this should be easiest to

   follow. However, perverse action is possible by way

   of flooding the stakeholders with so much unwanted

   and unnecessary information that the very

   purpose is lost. An obvious example is the

   prospectuses for IPOs that have bloated to hundreds

   of finely printed pages in which a crucial piece of

   information might lie buried. Regulatory efforts of

   reducing the information overload by asking for

   abridged prospectuses were thwarted by expanding

   those too to touch a hundred pages and the regulator

   was forced to limit it to ten pages by providing a

   rigid structure. There are issues about the cost of

   information and the infrastructure needed to access

   information. There are no easy solutions.

4. Ethical Perspective
   

   Stakeholders including individual employees

   and their representative bodies should be able to

   freely communicate their concerns about illegal or

   unethical practices to the board and to the competent

   public authorities and their rights should not be

   compromised for doing this. Almost all countries,

   by now realize the importance of promoting trust

   in societies. Trust is the backbone of all business

   and one common characteristic of all economically

   undeveloped societies is their trust deficit. Providing

   protection to the whistleblowers is a necessary

   condition for developing trust in a society, though

   it is not of course, sufficient. The provision of legal

   framework for whistleblower protection is not

   enough unless there is change of mindset within the

   companies. Sometime, the company insiders think

   of whistleblowers as traitors. The Boards are still to

   learn not think of whistleblowers as trouble makers

   or nuisance but an ally.

Integrated Reporting as a Paradigm of

Stakeholders’ Importance

7. A new kid on the block is Integrated Reporting

(IR) which is promoted by International Integrated

Reporting Council (IIRC). The main premise of IR is that

financial capital is not the only capital that is used by

the companies. Reporting is one-sided and incomplete

if it is confined to recounting how a company utilizes

equity and debt. When the investors invest in the capital

of a company, it is expected that the management

will run the company in such a way that the invested

capital will be enhanced and will also yield dividends.

Regeneration of and accretion to capital is the hallmark

of a successful business. A business uses many

capitals other than financial capital. For example, a

company uses buildings and plants in carrying out

its activities. A company that takes good care of its

buildings and plants and keeps on adding to their value

and functionality will be more successful in the long run

than one which does not take care. The neglect or the

abuse might not immediately reflect in their financial

statements. Bankers know this fact instinctively. That

is why they always make it a point to visit the plants

of a company before taking a final decision to lend.

They know that financial statements are not enough.

This kind of capital is called Manufactured Capital (MC)

in the IR parlance. The Manufactured Capital might

belong to the company or it might belong to society.

For example, roads and ports are publicly owned

Manufactured Capital. A company may enhance the MC

during a year or it might destroy it. A mining company

might think that it is being smart in overloading its

trucks and showing a little better financial profit. Yet in

the long run, it will be damaging the roads it uses and

the costs will escalate exponentially in future. It must

be now obvious why Manufactured Capital should be

accounted for.

8. Most of the companies now do account for their

Intellectual Capital in the sense of patents. There is a

little more to intellectual capital than simply patents.

It is the sum total of processes and procedures that

are embedded into the business model of a company

that marks an outstanding company from its mediocre

counterparts. These processes and procedures are what

give confidence to the suppliers and customers about

the consistency and reliability of the company. Even

this type of intellectual capital is to be recognized and

attempts need to be made that it is enhanced over a

period of time rather than letting it deteriorate. Closely

linked to it is Human Capital. There was a time in the

beginning of Industrial Revolution when financial

capital was most important for a company because other

factors of production viz. land and labor were considered

as a commodity. Labor was surplus and was unskilled.

One pair of hands was as good as another. If one

laborer fell sick or died, another quickly replaced him.

Learning at the job took a couple of hours at the most.

These days, it takes months or even years to train a

newcomer. It is the finance that has become a commodity.

You can get it from anywhere in the world at the

click of a mouse. At the very worst, you might have

to pay a few basis points more. On the other hand,

it is often impossible to fully replace a creative and

knowledgeable employee. Companies like Google are

entirely dependent on the skill and creativity of their

employees. Human capital, therefore, needs to be

recognized and accounted for.

9. No company can exist in a vacuum. It is a part of

the society and uses inputs put in by the society. For

example, software companies often employ engineers

trained by the local engineering colleges. If they neglect

to help these colleges to upgrade themselves, they will

lose out on the quality of future recruits. On a broader

scale, a company can operate only till such time as

the society gives it the license to operate. The day, the

company loses that goodwill, its days are numbered.

Therefore, it is necessary to also account for Social

Relationships, like we do for other types of capital.

10. Last, but absolutely not the least, is the natural capital

that a company uses. Every business uses air and water

though it might not always be obvious. It is not only

the power plants that use enormous quantities of water.

Integrated chip manufacturing involves unbelievably

large quantities of water. There was a time it was

considered kosher to abuse the environment thinking

that only the future generations will pay for it. It is no

longer true. The environmental balance has reached

such a delicate stage that the environmental debts are

to be paid here and now.

11. Integrated Reporting is a comprehensive and also a

compact way to look at all the stakeholder interests in a

corporation.

Conclusion

It is a situation where the reporting practices and

management practices have clearly overtaken the theory of

corporate governance. No practical manager ever questions

the importance of Customer Relationship Management or

Supply Chain Management. Human Resources Development

and customer-centric behavior has become modern

managements’ article of faith. It is for the corporate

governance theory to change itself to keep pace with the

practice. In short, it is moving from the linear thinking of

about shareholder value to the n-dimensional space that

includes everyone.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.