The dilemma in corporate governance

FIntroduction

INANCIAL institutions are always in a dilemma when it comes to who to give higher priority between shareholder wealth maximisation vs stakeholder welfare as a corporate objective.

The shareholders being the key controllers may want the company to focus on improving financial performance.

On the other hand, stakeholders want to incur expenditure that increases their value but does not necessarily add to profitability, especially in the short term.

With changing economic dynamics financial institutions have now started treating increasing stakeholder value as a part of corporate social responsibilities and this has inevitably created some tension in the quest for financial institutions to be wealth-maximising while ensuring public safety and soundness.

Sources of tension

Profit motive

The profit motive lies behind several cost-cutting initiatives undertaken by financial institutions that have had the effect of benefiting shareholders at the expense of other stakeholders, employees in particular.

For example, the quest for lower labour costs has led to the offshoring of numerous jobs, resulting in unemployment/underemployment and stagnant or deteriorating incomes for many lower and middle-class workers, setbacks that may not be temporary.

Furthermore, cost reduction pressures have been largely responsible for a declining incidence of corporate pension plans as well as reductions in healthcare coverage for employees in the corporate sector.

Unethical practises/rogue elements

The failure of corporate governance and by extension, the agency problem, was identified to be the major cause of the crisis. Financial institutions may engage in unethical and potentially fraudulent business practices. This is likely to lead to the enrichment of senior top management executives to the detriment of the shareholders and depositors.

Albeit financial institutions are growing in size, the boards of the institutions may overlook their role of monitoring and checking management.

Unethical practices of setting up SPV’s (special purpose vehicles) to siphon the depositor’s funds could be prevalent.

These practices show that tension arising from attempting to be wealth-maximising entities while ensuring public safety remains an issue as the management may no longer be acting in the interest of the agents (i.e. the depositors and the shareholders).

Compensation

For example, all other things equal, it will be in employees’ interests to receive as much compensation as possible.

However, any compensation to employees beyond what is required to retain them in the firm, at the desired level of productivity, reduces the cash flows available to shareholders — and therefore runs contrary to shareholder interests.

If management is to ignore market values in determining employee compensation, by what alternative means should they determine how much value to take away from one set of stakeholders (the shareholders) and give to another set of stakeholders (the employees)?

Contradicting interests

Shareholder wealth maximisation should be the primary objective of managers and employees in any corporation. “The wealth of corporate owners is measured by the price of the common shares which in turn is based on the timing of returns (cash flows), their magnitude and their risk”.

All decisions made by the firm should support the maximisation of shareholder wealth. While shareholders are one of the important stakeholders of an organisation, it is purported that they are not the only ones that should be considered when making decisions.

Public safety and soundness should be an integral aspect and given due precedence. In stakeholder capitalism corporations are expected to behave with greater social responsibility and be sensitive to the ethical considerations of their actions thus creating friction and ultimately leading to tension in the quest to be wealth maximising as well as ensuring public safety and soundness.

It is clear that when a company adopts a radical strategy geared solely towards the defence of its shareholders’ interests, it is likely to wrong many stakeholders.

In turn, this can be damaging to financial institutions. Thus, it is the financial institutions’ clear-cut interest — and this alone — that forces firms to think about their stakeholders .

It may not be possible to maximise the longterm market value of an organisation by ignoring or mistreating any important constituency.

It is insurmountable to create value without good relations with customers, employees, financial backers, suppliers, regulators and communities.

In the shareholder perspective, the goal of corporate governance is to focus on the company, thus on stakeholders only to the extent that this is required by law and by concerns for the firm’s reputation, credibility and image.

The stakeholder vision of corporate governance is systematically incompatible with shareholder interests hence tension.

Separation of ownership

and control

Separation of ownership and control, while it has obvious benefits creates a conduit for tension. It is evident to note that a potential conflict of interest is created. That is the overriding objective of stock price maximisation that can be placed behind any number of conflicting managerial goals.

For example, managers may act to increase his/her own welfare in the form of increased salaries, add more benefits or perquisites in the form of lavish parties or vacations. Other forms of conflicts would be managers acting too conservatively about investment spending, increasing their job security by hand-picking the members of the Board of Directors, or adding assets simply to reflect personal hubris rather than to add to stockholder wealth. : If managers own most of the company they will be inclined to make decisions that will increase the wealth of the company; if managers own only a small percentage of the company the incentive to act in the best interests of the stockholders can become diluted

Externalities

Promoting social welfare is widely regarded to be the primary function of social systems, prominently including the financial system even if shareholder wealth maximisation had been found to be tightly linked to economic efficiency at the firm level, firm-level efficiency does not always lead to greater aggregate economic wealth.

In particular, negative externalities, situations in which firms do not bear the full cost of their decisions, thus imposing costs on others, occur with some frequency. Many actions that increase firm profitability harm other stakeholders.

Priority

Although there is some debate regarding which stakeholders deserve consideration, a widely accepted interpretation refers to shareholders, customers, employees, suppliers, and the local community.

According to the stakeholder theory, managers are agents of all stakeholders and have two responsibilities: to ensure that the ethical rights of no stakeholder are violated and to balance the legitimate interests of the stakeholders when making decisions.

The objective is to balance profit maximisation with the long-term ability of the corporation to remain a going concern.

The fundamental distinction is that the stakeholder theory demands that the interests of stakeholders be considered even if it reduces company profitability.

Unfortunately, shareholder theory is often misrepresented.

The shareholder theory is geared toward short-term profit maximisation at the expense of the public interest and safety.

It is also common for the shareholder theory to prohibit giving corporate funds to things such as charitable projects or investing in improved employee morale.

In fact, however, the shareholder theory supports those efforts insofar as those initiatives are, in the end, the best investments of capital that are available.

Solutions Empowering management

Corporate decision-making is more efficient and effective when management has a single, clearly-defined objective and shareholder wealth maximisation provides not only a workable decision guide but one that, if pursued, increases the total wealth creation of the firm.

This, in turn, enables each group to obtain a greater share. Thus, employees who seek greater job security or expanded benefits, which advocates of stakeholder management would support, are more likely to get these goods if the employing company is prospering. A similar argument can be developed for customers, suppliers, investors, and every other stakeholder group.

The benefits of a single objective would be compromised if other groups sought, like shareholders, to protect themselves with claims on management’s attention.

It is prudent for financial institutions to protect or serve each stakeholder group’s interests. On the economic approach, what each group is due is a return on the assets that they provide for joint production, and each asset is accompanied by a governance structure that protects this return. The distribution of the benefits or wealth that firms create is largely determined by the market, and the main concern of governance is to ensure that the group receives what the market allots.

There are many means for securing each group’s return, one of which is reliance on management’s decision-making powers. In the prevailing system of corporate governance, this means is utilised by giving shareholders control, making them the beneficiaries of management’s fiduciary duty, and setting shareholder wealth as the objective of the firm.

Treating all stakeholders as

shareholders

Insofar as it proposes that managers have a fiduciary duty to serve the interests of all stakeholders and that maximising all stakeholder interests be the objective of the firm, it seeks to extend the means used to safeguard shareholders to benefit all stakeholders.

The fundamental mistake of stakeholder management is a failure to see that the needs of each stakeholder group, including shareholders, are different and that different means best meet these needs.

The protection that shareholders derive from being the beneficiaries of management’s fiduciary duty and having their interests be the objective of the firm fit their particular situation as residual claimants with difficult contracting problems, but employees, customers and suppliers.

Structural controls in corporate governance

Corporate governance is concerned with how business organisations should be legally structured and controlled. The provisions that management has a fiduciary duty to serve shareholder interests and that shareholder wealth maximisation should be the objective of the firm dictate how decisions about major investment decisions and overall strategy should be made.

Stakeholder management, then, as a guide for managers rather than a form of corporate governance, provides a valuable corrective to managers who fail to appreciate how shareholder primacy benefits all stakeholders and use it as a reason for disregarding other stakeholders.

Such managers commit a mistake of their own by confusing how a corporation should be governed with how it should be managed. There is no reason why managers who act in the interests of shareholders and seek maximum shareholder wealth cannot also run firms that provide the greatest benefit for everyone.

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