Shareholders v. Stakeholders: The changing paradigm in corproate governance

ORIGINS OF CORPORATE LAW

The paradigms of corporate law have always been fascinating and intriguing for various reasons. Their origin is equally interesting. Formation of companies was initially due to the need for funds from various sources, which were neither forthcoming from the hitherto existing business structures like the partership concerns nor were available on loan for the ideas were either too risky or not the returns promised were not very profitable. This can hardly be understood today unless one imagines the business atmosphere of 15th and 16th century wherein it the domestic trade requirements had been satiated, the only means to expand was to look for other places in the world; just the time when explorers like Vasco-Da-Gama, Amerigo Vespucci, Christopher Columbus and others had just come back from their risky voyages and told their inhabitants of the United Kingdom that there were people outside Europe as well and they needed to take initiative and expand there as well.

It was in this scenario that those who longed to take initiative and march out to the newly discovered worlds found other people with funds but not too enterprising who could lend them out to them on otherwise not so commercial viable rates but only because of the promise of getting a share in the profits. And thus the shareholders in profit were born, not the ones which acted upon the business ideas but merely contributed capital and allowed others to pool in their spirit and enterprise and take a share in the profits earned on a whole by these enterprising man investing the capital generated by these shareholders. No wonder 'share' is understood as 'a share in the share capital of the company' which in a disillusioned sense would mean 'a portion of contribution (and entitlement to reward) in the common pool of resources of the company'.

This arrangement for pooling in capital was legally recognized when the Crown started issuing 'Royal Charters' (though initially on a selective basis), giving the common pool a separate legal identity and giving it various features (like, limitation of each individual's liability, etc.) and slowly we had a generalized law with benchmarks following which any group of two or more people could form a company. In this feature what was novel was the presence of entities which owed their existence to legal fiction. Originally this was something peculiar for though the bulk (and in some cases entirely, as it happened in Soloman v. Soloman & Co.) of resources were contributed and majority of functions were performed by a group of closely related individuals, still they were fictionally divested from the enterprise because of an artificial distinction made in law. Later, however, with more and more instances being recorded of companies with shareholders who were unknown to each other and were related only because they owned a share in the company, the things came to be understood differently, and the modern day company was born.

SHAREHOLDER MODEL

The above sketching of the historical evolution of company law would the essential and close linkages between a company and shareholders. On these lines, it was essentially understood and presumed that the company acted in the best interests of the shareholders i.e. the contributors to the capital stock and that the company's directors owed (in some qualified sense) a fiduciary duty to the shareholders, in whose interests they acted and sought to maximize the returns to their wealth. This belief was, however, shaken when a lawyer and an economist argued over the essential premises on which companies operated and surveyed the existing state of affaris in the 1930s and based upon their findings and arguments, published a book titled "The Modern Corporation and Private Property". These two; Adolf Berle and Gardiner Means, shook the notions of the contemporary understanding of the masses as regards the working of the corporations and the dive station of ownership from management of the corporate capital stood exposed.

This led to a wide spread debate on governance; corporate governance that is. Having witnessed that corporate heads did not actually and at all times, think in the best interests of the shareholders, theories began to be developed and regulation strengthened to ensure that the Directors performed the functions for which they were appointed by the shareholders i.e. maximizing shareholder's wealth. In the late 1990s, the debates on good governance versus bad governance stole the lime light and were perhaps the only topics for discussions and studies across almost all jurisdictions in the world. Studies were conducted and reports issued on the ways to ensure good governance in the helm of corporate affairs and to detach the director from acting in his own interests to make way for the resources of the companies to be used in the most efficiently possible manner. The Report of the Cadbury Committee stands out the most amongst these various initatives. [click here for the entire report] The strengthening of regulations on insider trading etc. were also the other outcomes of this increasing hue and cry for good governance.

STAKEHOLDER MODEL

The above narration would clearly reveal that the entire spectrum for corporate governance were the shareholders. All questions in management were to be decided on the sole basis that whatever was best for the shareholders was to be adopted. This came to be recognized as the 'shareholder model' when societal concerns were sought to be matched with the increasingly rising profits of the corporations. Issues such as 'Corporate Social Responsibility' i.e. a corporation owes a responsibility to the society in which it operates and therefore has to act upon it, etc. came to be raised and were being argued vigorously in the early days of the 21st century.

The basis for the argument was that since the corporation made profits by exploiting the resources it took from the society, it had a responsibility to return a share of profits it made from such exploitation back to the society instead of all being offered to a handful of shareholders. Further the notion that corporations could work only because the law granted it privilege to do business in its own name and such could not have been possible had no such privilege being granted, therefore the corporation owed a responsibility to share the benefits it derived from such privilege with the post-holders of law, which applying a welfare-state concept meant, that the corporation was obliged to share the benefits of corporatization with the society on a whole.

This was the beginning and essence of the 'stakeholder model' which meant that the corporation had to act in the best interest of not the shareholders alone but of the stakeholders on a whole; wherein stakeholders was a term used to collectively refer to all those who owed/owned an interest (stake) in the functioning of the corporation. Therefore, for illustration, the stakeholders of a corporation operating in a village would mean all the villagers (for they suffer from the pollution created by the corporation), the village administration (for they were responsible for the disturbance created by the corporation in the normal functioning of the villagers), the employees of the corporation (for they contributed to the well-being of the company and therefore are entitled to share proceeds from the benefits earned by the company from their sweat and toil), etc.

This sudden increase in the number of people and also the various classes of people to whom the corporation owed a responsibility meant that a significant amount of time and resources had to be diverted by the corporate managers to initiatives and activities which would not have opted for without such a responsibility and thus were at first evasive to such philanthropic concerns. Thus various countries sought to influence the corporate management's behaviour through legal means such as granting tax incentives, dealing only with such corporations which acted upon such shareholder models for government procurement, etc. Further, with the popularization of the movement of Corporate Social Responsibility (or CSR), the corporate management on their own thought wise to devote some portion of their resources (the proponents of CSR would argue that the proportion of these resources are still meager) to the well being of the general folk. However the issue (despite being a relatively new one) is very contentious and has seen an amazing response from the scholarly and academic mainstream.

Thus one may find that corporate governance has really come a long way and shows enormous potential to assume other significant issues within its fold, increasing the tension and paradigm of areas for corporate management to focus upon. The era of shareholders dictating terms to the corporate management has long passed with now most legal regimes making it mandatory for corporate management to follow extensive reporting requirements on the actions and efforts on their part in furthering the social cause and taking care of the stakeholders.

For further reading, I would recommend;

1. Government of UK's website on Corporate Social Responsibility and update on CSR
2. Nottingham University Business School's International Centre for CSR