Its time for an update of NZ governance

This is a summary of a longer submission to the Institute of Directors in NZ for their review of directors duties.

A PROBLEM OF SHAREHOLDER PRIMACY

A hugely influential but since discredited article by economist Milton Freidman in the New York Times in 1970 argued that maximising shareholder value is the only purpose of companies. While competing views were published at a similar time suggesting businesses could not exist without customers, or that employees are a company’s greatest asset, it was Friedman’s shareholder primacy that took hold at the boardroom table without a legitimate ethical underpinning.?

By embracing shareholder primacy and a view that money is all that matters in business, directors believed they had the mandate to do anything, within the law, to make money, and in fact that it was their sole obligation to do so. This, and the subsequent alignment of corporate remuneration to shareholder value, has done immeasurable harm and benefitted the few at the expense of the many. On Wall Street, greed is good.

Fortunately NZ does not enshrine shareholders primacy in the Companies Act 1993. Here it is the “duty of directors to act in good faith and in the best interests of the company”. Shareholders have specific and limited rights under the act - the appointment and removal of directors, agreement to constitutional change and major transactions, and rights to an equal share of dividends – but shareholders do not have primacy of rights when it comes to board room decisions. Those decisions must be made in the best interests of the company.

But the Institute of Directors in New Zealand has recently stated:

It is generally, although not universally, accepted that New Zealand company law is based on, and designed to reflect, the concept of shareholder primacy, which would dictate that acting in the best interest of the company means acting in the best interest of the shareholders

While I believe this interpretation is both legally incorrect and ethically wrong, I accept it is often the case in practice. In my experience, sitting on and reporting to numerous boards over the years, despite the clear duty in Clause 131 (1) of the Companies Act, there remains an unquestioned view by many, but not all, NZ directors that their principle responsibility is to shareholders, to the extent that this belief could be classified as some sort of commercial dogma, unquestioned and pervading.?

There are significant ethical problems with shareholder primacy. How can it be that invested capital - that’s just money by the way - has some sort of hierarchical rights and privilege above people or planet? I know of no ethical theory that could support such a proposition. But in many businesses, this is in fact how we behave. Making more money than last year is a standard objective, and incentives for management, both financial and non-financial, are aligned to making more money. Everything else is a trade-off. Sometimes we “sacrifice profit” to pay a better wage or fix a safety issue or reduce our pollution, but invariably we do this not to do good in-and-of-itself (ie for ethical reasons) but because in the long run it will be “good for business”, which just means profits.

Of course companies can make money, and plenty of it, to support ongoing business, make investments and pay dividends. That’s fine and its fundamental to financial sustainability. What I do assert is that money cannot have privilege over people or planet. Legally, directors of companies are already not obligated to adopt a shareholder primacy model, but I assert ethically they definitely should not do so.?

As such I have proposed that the IoD clarifies its position that acting in the best interest of the company does not mean just acting in the best interest of shareholders, and adjusts its guidance documents accordingly.?

A LARGER PROBLEM: COMPANIES ARE NOT CURRENTLY REQUIRED TO BE ETHICAL ENTITIES

Putting aside the wrongs of shareholder primacy, we also have another problem. Even for those directors who have moved past a shareholder centric belief, the legal obligation under the Companies Act that directors act in the best interest of the company, can often be construed as taking a selfish view. Companies are allowed to do anything to their benefit, so long as its legal. There is no obligation to do good or to avoid harm, just an obligation to obey the law; to be compliant.?

So directors acting in the best interest of the company can allow their companies (and shareholders) to benefit by ignoring, or at least discounting, the environmental or social harm they cause, and by acting in the best interests of the company directors appear willing to extract benefit by transfers to the company from collective societal or planetary assets, at a cost to people and planet.?

This is clearly an insufficient constraint.?Legal yes, ethical no – and its a problem with governance that needs to be addressed.

Companies hold a number of privileges in law. They are separate legal entities, legal persons so to speak. They have the full capacity to act. And the company, and their investors, have the very special privilege of limited liability.?

That’s a privilege I don’t have as a legal person.?

Privileges should be balanced with obligations, and I suggest that companies, these “legal persons with special privileges” should be held to a higher level of ethical standards than natural persons. Somehow we need to move governance thinking from “doing the right thing is good for business” (the reputational view), to “doing the right thing is the obligation of business” (the ethical view).?

A reputational view is about trade-offs, whereas an ethical view often creates firm boundaries on behaviour and action.

How might such a change be implemented? The Institute of Directors currently has a written Code of Practice. While this code does reference ethical standards for directors (via the Values of Integrity, Enterprise, Fairness, Transparency, Accountability and Efficiency) there is no reference to ethical standards of the actual company itself.

So it is my proposition that the IoD should review and strengthen its Code of Practice for Directors to include more specific ethical standards for the companies being governed and that membership of IoD should include a pledge of personal commitment to whatever new standard is adopted.

What might an ethical standard entail? Here are some types of ethical principles that might be considered:

a. People have rights. Companies need to have respect for individuals, uphold human dignity and allow certain freedoms. A company’s consideration of these rights would be applicable to the nature of work and the employment relationship. Rights would also apply to the relationship with customers and impacts on people within supply chains

b. Environmental ethics – including consideration of issues of pollution (water, air and land), resource use, sustaining biodiversity, protection of pristine or important natural or heritage places, animal welfare, kaitiakitanga.

c. Distributive justice – how should income and wealth and opportunities and the good things in life be distributed? Equality of opportunity as a minimum, but there are other considerations too. For example what is fair when comparing senior executive remuneration to that of the least advantaged employee? This also brings us back to consideration of the balance of shareholders benefits vs those of other stakeholders, in particular employees

While some or all of these forms of ethical principles, adopted as simple standards, might be considered in a revised Code of Practice for Directors, I would view one ethical principle as paramount; first, do no harm.

Companies should not have the right, as part of their normal operating practices, to do harm. While in principle this seems obvious, practically and in particular from a starting point of current operations in existing businesses it may be difficult, perhaps impossible, to implement. So maybe the new ethical obligation on directors should be to eliminate harm where they can, and where elimination is not possible to instead minimise harm. Actively minimise harm.

We are fortunate we already have legally defined obligations on directors to minimise harm contained in the country’s health and safety legislation. The Health and Safety at Work Act 2015 requires that workers and others are given the highest level of protection from workplace health and safety risks, so far as it is reasonably practicable.

So we could broaden that requirement on companies and directors to identify and evaluate all forms of harm, and to take action where practicable. For example, we could incorporate into the Code a standard like:

Directors of all companies, shall routinely assess all potential and actual sources of harm to staff?and other persons, to the environment and biosphere, to pristine natural places and waterways, and to the communities in which they operate, and take all practicable steps to firstly eliminate that harm, and where elimination is not possible, to minimise that harm. This obligation on directors also applies to the management of, and relationship with, the Company’s supply chain and contractors.

The implementation of such an obligation on directors would mean profit could not be derived from harm if there are practicable steps that could be taken, or investments that could be made, to address that harm within the financial means of the company. So addressing harm would take priority over shareholder returns. Such an obligation on directors would both break the concept of shareholder primacy and eliminate the practice of companies benefiting from ignored negative externalities.

And to further strengthen this standard, such an obligation on directors could become a legislated requirement in a new or revised Companies Act. So I also propose the IoD should promote and support such a change to company’s law.

SUMMARY OF RECOMMENDATIONS

In my submission to the NZ institute of Directors I make the following recommendations:

1. That the IoD clarifies for members that their obligations under the Companies Act to act in the best interests of the company does not mean just acting in the best interests of shareholders, and ensure all IoD training courses and publications reflect this.?

2. Update the IoD Code of Practice for Directors to incorporate new ethical standards for the companies being governed and ensure all members of the IoD pledge to observe this code as part of their ongoing membership. As a minimum this would include an obligation on directors and companies to take all practicable steps to eliminate or minimise harm, but might also include other ethical standards.

3. Endorse a change to the Companies Act that legalises the obligation of company directors to eliminate or minimise all types of harm where practicable.