On shareholder value and the fiduciary duty of directors

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By Ali Abdi

“On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy” – Jack Welch, Former CEO, General Electric

Simplicity is not always a virtue. In particular, simplicity is not a virtue when it leads to misconceptions and mistakes.

Over the last decades, the term “shareholder primacy” has become synonymous with the perspective that the purpose of the corporation is to maximise shareholder wealth. However, questions arise as to whether the primary corporate objective of a company is simply to increase the shareholder wealth, or whether companies have wider responsibilities to benefit stakeholders and society in general? Further, is the objective inextricably linked to the duties of directors?

The above perspective is what led to the theoretical framework for the shareholder versus stakeholder debate, which significantly shaped subsequent legal discourse on the scope of shareholder wealth maximization. Adolf Berle, a neo-classical proponent in “Corporate Powers as Powers in Trust’ (1930) 44 Harvard Law Review 1049” argues on corporate objective that directors are trustees for the company’s shareholders. He states that all powers granted to the directors of a company are, at all times, exercisable only for the benefit of shareholders, for whom money is to be made. He believes, because the power to run a company has been delegated from the shareholders to the directors, the latter has the sole responsibility to run the corporation in the interests of those shareholders.

On the other hand, Merrick Dodd, in “For whom are Managers Trustees?’ (1932) 45 Harvard Law Review 1145, argues that a corporation becomes a distinct legal entity upon incorporation and as such viewed the company as more than just a collection of shareholders and should be obligated to fulfil a social service role. He states that the law was in favour of treating the company as an institution directed by persons who are fiduciaries for the institution rather than for its members by putting the interests of the company first.

Traditionally, directors under common law owe the fiduciary duty to act bona fide for the interest of the company. This, by and large, is construed from the best interest of the company prism of advancing shareholder value. However, on a closer look, there are two interpretations of the phrase “the interests of the company”. The first is that the duty requires directors to run the company for the benefit of the shareholders; the interests of the company being equated with the interests of the shareholders. The second is that the interests of the company means what is best for the company as a separate legal entity. This approach recognises that the interests of the company and the shareholders may well diverge. It would also require directors to consider and take decisions in favour of interests other than shareholders, where such action would benefit the company as a separate entity.

At this point the first interpretation leads to what is known as a shareholder value approach which dictates that the sole focus of a company is to maximise wealth for shareholders and has long been associated with directors seeking to maximise profits in the short term which in turn is closely linked to corporate collapses. This view fails to reflect the fact that is impossible for a company to successful in the long term while consistently acting to the detriment interests of stakeholders and on wider society.

The second interpretation on the duty to act in the interests of the company as meaning a duty to act in the interests of the company as a separate legal entity is the superior approach since it removes many of the negatives that result from applying shareholder value. In addition, to simply equate the interests of the company with the interests of the shareholders is a legally flawed approach.

In Dodge v. Ford Motor Company 170 NW 668 (Mich, 1919), Ford Motor Company announced a policy of reducing dividends in order to subsidise the sale price of Ford cars. The aim of the policy was to stimulate the market, increase company sales and thereby secure the jobs of the company’s employees.  The Dodge brothers, as shareholders, argued this approach was at the expense of shareholders and an improper use of power. The court held that such a policy was not proper as it was not in the interests of the company’s shareholders and stated, “The business corporation is organised and carried on primarily for the profit of shareholders.”

However, the above case is a widely misunderstood judicial opinion. But, nearly a century-later, it is still the most widely cited “legal proof” of shareholder primacy validity. What needs to be emphasised is that this case was actually about a closely held company and the duty of a controlling majority shareholder (Ford) to its minority shareholders (Dodge). The Michigan Supreme Court’s comment, “a business corporation is organised and carried on primarily for the profit of the stockholders”, is what legal experts call mere obiter dictum – a comment made in Court that is merely a judge’s editorialising, and does not directly address the specifics of the case at bar, nor is necessary to arrive at the holding. Mere dicta is not worthy of setting precedents.

Interestingly, under common law,  a company’s interests are often viewed as synonymous with shareholders’ interests and the best interests of the company has been equated by the courts to mean the best interests of shareholders.  In Brady v. Brady [1988] 3 BCC 535, 552, Nourse LJ was of the view that “The interests of a company, an artificial person, cannot be distinguished from the interests of the person who are interested in it. Who are those persons? Where a company is both going and solvent, first and foremost come the shareholders present and no doubt future as well.”

The shareholder value maximisation theory became so commonplace that although most of its proponents could not even recall its roots, the dogma was summarily accepted. Contrary to popular belief, shareholder primacy theory is just that – a theory. In sum, whether gauged by corporate charters or corporate case law, the notion that corporate law as a positive matter “requires” companies to maximise shareholder wealth in my view turns out to be spurious and that the offhand remarks on corporate purpose to maximise shareholder wealth lacks any foundation in actual corporate law.

Shareholder value approach

The shareholder approach also named as the shareholder primacy model, operates on the core concept that the ultimate objective of a company is to maximise wealth for shareholders. This concept provides the primary legal support for the shareholder primacy model. Further, it adopts the view that directors should be obliged to act exclusively in the interests of shareholders, which is also regarded as “the substance of the corporate fiduciary duty”. In general, there are three major arguments in favour of the shareholder primacy model.

The first is that even though corporate law scholars avoid exploring the fact whether shareholders are owners of companies generally, and sometimes they deny that shareholders are owners of the company, they assume that shareholders have proprietorial interests in the company akin to ownership.

Secondly, the most quoted argument in favour of this approach is that shareholders are the “residual claimants” when the company is solvent. It is believed that a company should be accountable for the benefit of the residual claimants, as shareholders being the equity investors are the “greatest stake in the outcome of the company”. They may benefit from the company’s surplus, but they also bear a greater risk than other constituencies as their interests are not adequately protected by contractual means under most circumstances. Thus, they should be given a right to control above other stakeholders because their interests are associated with every decision they made for the firm. Unlike shareholders, interests of non-shareholder constituencies are better protected by legal mechanisms like contract law, rather than an involvement in corporate governance.

Thirdly is the reduction of agency costs. Under the agency theory, it is known that the agent, namely the directors, should act on behalf of the shareholder’s interests in running the business of a company. However, in the absence of the shareholder primacy, it is likely that the directors will “shirk” their duties and agency costs will be incurred to monitor their work so as to prevent their abuses in positions. In order to reduce the agency costs, the effective way is to uphold the shareholder value that directors are made accountable to shareholder’s interests.

Under common law, it was possible for directors to take into account stakeholders’ interests so long as it promoted the interest of the company for the benefit of shareholders as a whole. This was illustrated by the case of Hutton v. West Cork Railway (1883) 23 Ch D 654.  Where Bowen LJ gave the often cited statement, “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”. Further, in Re Smith and Fawcett Ltd. [1924] Ch 304, Lord Greene, speaking in the Court of Appeal, observed “rectors must act, bona fide, in what they consider – not what the court considers – is in the best interests of the company.”

Critics of maximising shareholder wealth are of the view that the shareholder primacy theory, which tries to explain the idea that corporations should, on the face of it, be managed to maximise shareholder value, is based on factually mistaken claims about the law.

The first fallacy is the belief that shareholders own corporations. Although laymen sometimes have difficulty understanding the point, corporations are legal entities that own themselves, just as human entities own themselves. What shareholders own are shares, a type of contact between the shareholder and the legal entity that gives shareholders limited legal rights. In this regard, shareholders stand on equal footing with the corporation’s bondholders, suppliers, and employees, all of whom also enter contracts with the firm that give them limited legal rights.

A more sophisticated but equally mistaken claim is the residual claimants’ argument which posits that shareholders are entitled to all the “residual” profits left over after the firm has met its fixed contractual obligations to employees, customers, and creditors. However, recent economic theories suggest that shareholders generally are not and probably cannot be, the sole residual claimants in firms. For example, the modern options theory teaches that business risk that increases the expected value of the equity interest in a corporation must simultaneously reduce the supposedly “fixed” value of creditors’ interests and that the legal rule requiring corporate directors to maximise shareholder wealth ex post might well have the perverse effect of reducing shareholder wealth over time by discouraging non-shareholder groups from making specific investments in corporations ex ante.

Thirdly, the common but misleading claim on shareholder primacy is that directors and executives are shareholders’ “agents.” At law, it is trite that a fundamental characteristic of any principal/agent relationship is the principal’s right to control the agent’s behaviour. In this view, shareholders lack the legal authority to control directors or executives. Traditionally, shareholders’ governance rights in public companies are limited and indirect, including primarily their right to vote on who sits on the board, and their right to bring lawsuits for breach of fiduciary duty.

Finally, it is becoming increasingly well-understood that when a firm has more than one shareholder, the very idea of “shareholder wealth” becomes incoherent. Different shareholders have different investment time frames, different tax concerns, different attitudes toward firm-level risk due to different levels of diversification, different interests in other investments that might be affected by corporate activities, and different views about the extent to which they are willing to sacrifice corporate profits to promote broader social interests, such as a clean environment or good wages for workers. These and other schisms ensure that there is no single, uniform measure of shareholder “wealth” to be “maximised.”

Accordingly, from the above economic theories, we understand that corporations are not run best when they are run according to the principle of shareholder wealth maximisation. Not only is shareholder wealth maximisation a bad legal concept from a positive perspective, but it is also bad law from a normative perspective. This, in my view, leads to the corporate objective question on how then can we equate the best interests of the company with the shareholders’ best interests?

The best interests of a company

Under Company Law, it is a fundamental principle that the company is a legal entity which is distinct from its shareholders. The case which laid down this principle of separate legal personality was Solomon v. A Solomon & Co Ltd [1897] AC 22, 30, where Lord Halsbury LC stated, “Once the company is legally incorporated, it must be treated like any other independent person with its rights and liabilities appropriate to itself, and that the motives of those who took part in the promotion of the company are absolutely irrelevant in discussing what those rights and liabilities are.”

Lord McNaughton in the above case said that the corporation at law is a different person entirely from the subscribers to the memorandum of the company. Since the judgment in Solomon, there has been widespread juridical support of this separation between the company and its shareholders.  In Credit Suisse v. Allendale Borough Council [1997] QB 309, 359, Hothouse LJ held, “it is elementary law that shareholders are not to be identified with the corporate entity even if there is only one shareholder”. Similarly, Lord Millet in Johnson v. Gore Wood & Co (A Firm) [2002] 2 AC 1, 61 defined that the company as a legal entity “separate and distinct from its members”.

In Redfern v. O’ Mahony and McFeely, Carroll, Tafica Ltd and Aifca Ltd [2010] IEHC 253, McGovern J stated, “The legal consequences of incorporating a limited liability company are that the company assumes a separate legal identity as distinct from its owners. This is not a fiction. The rule in Solomon v. Solomon & Co Ltd [1897] AC 22 is still the law in this jurisdiction. The company and its shareholders are separate legal entities.”

Following on from the doctrine that the company is a separate legal person, directors owe their fiduciary duties to the company itself and not to any individual shareholder or group of shareholders. As held in Crindle Investments et al v. Wymes et al [1998] 2 ILRM 275, 288 – “…there can be no doubt that, in general, although the directors of a company occupy a fiduciary position in relation to the company, they do not owe a fiduciary duty, merely by a virtue of their offices, to the individual members” – therefore, from a judicial standpoint, the shareholder value does not have to be the approach taken. Not all cases on this topic say that the interests of the company are synonymous with the interests of shareholders.

As respect to the potential conflict between the interests of shareholders and those of the company, it seems in my view that where the proposed act is required to be done in the interests of the company, the interests of the company prevail.

In Peoples Department Stores Inc. (Trustee of) v. Wise [2004] 3 SCR 461, the Canadian Supreme Court held that the duty to act in the best interests of the company is not to be simply equated with acting in interests of the shareholders. “Insofar as the statutory fiduciary duty is concerned, it is clear that the phrase the `best interests of the corporation’ should be read not as simply the ‘best interests of the shareholders’. From an economic perspective, the `best interests of the corporation’ means the maximisation of the value of the corporation. However, the courts have long recognised that various other factors may be relevant in determining what directors should consider in soundly managing with a view to the best interests of the corporation.”

This approach recognises the legal reality that the corporation is a distinct entity by acknowledging that doing what is best for the company, even from an economic perspective, includes considering non-shareholder interests. The court goes on to say, “We accept as an accurate statement of law that in determining whether they [the directors] are acting with a view to the best interests of the corporation, it may be legitimate, given all the circumstances of a given case, for the board of directors to consider, inter alia, interests of shareholders, employees, suppliers, creditors, consumers, governments and the environment.”

It is thus trite, according to the above case law, to state that there is no principle that one set of interests – for example the interests of the shareholders – should prevail over another set of interests. Everything depends on the particular situation faced by the directors.

Based on the well-established legal doctrine of separate legal personality and the nature of directors’ fiduciary duties, in addition to case law, Kenyan Courts ought to, under the Company Act, 2015, provide better interpretation of what it means to act in the best interests of the company. This would not only offer a truer reflection of the legal nature of a company but also provide a chance to better promote both private and social wealth through company law. ^

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