Redefining the purpose of a corporation – theory or practice?

Posted on January 20, 2019

Cristina Stoica
Cristina Stoica
Manager Corporate Governance

In August 2019, the U.S. Business Roundtable (BRT), a non-profit association composed of corporate CEOs, issued a statement redefining the purpose of a corporation. The BRT has defined a corporation’s purpose as working for the benefit of all stakeholders, such as customers, employees, suppliers, communities where the company operates, as well as shareholders. Drafted following months of consultation with CEOs and members of the political, academic and NGO sectors, the statement was signed by 181 CEOs, or 95% of BRT members (though not by the companies they represent).

The statement declares each stakeholder group to be essential for the long-term success of any business. Signatories to the statement commit to:

  • Deliver value to their customers
  • Invest in their employees by providing fair compensation and benefits, investing in training and continuous learning, as well as foster diversity and inclusion
  • Deal fairly and ethically with their suppliers
  • Support the communities in which the companies operate by respecting the people as well as the environment by embracing sustainable business practices
  • Generate long-term value to its shareholders who provide capital, by committing to transparency and constant engagement.

The redefined purpose represents a significant shift from the BRT’s previous statements, first authored in 1997, that the purpose of the company is solely to maximize shareholder return. However, in a follow-up statement, BRT made clear that it does not support radical corporate governance changes derived from the new principles, as such changes may become disruptive for the U.S. market.

Although the statement was initially well received, not all reactions were positive. The Council of Institutional Investors (CII), a non-profit organisation representing the U.S. pension and employee benefit funds with assets of more than USD 4 trillion, openly opposed the new articulation of the purpose of a corporation. CII asserts that the BRT statement effectively relegates shareholders to the role of capital provisioners, while leaving their ownership interest unaddressed. By extension, CII believes the new principles generate a risk of diminished shareholder rights and does not provide mechanisms of accountability for a company’s stakeholders.

Shareholder primacy theory – history and effects

The BRT has periodically issued principles of corporate governance since 1978. Each of the previously issued versions has followed the shareholder primacy theory, which defines the main purpose of a corporation as maximizing shareholder value. Management and the board were accountable to stockholders first and the interests of other stakeholders such as employee were only “relevant as a derivative of the duty to stockholders.”

The previous corporate governance statement issued by the BRT, as well as many of the U.S. corporate governance standards and practices over the last decades have been based on a theory first published by economist Milton Friedman in a 1970 essay. Friedman’s theory considers a company’s responsibility to maximize profits for its shareholders as its only means to achieve economic success. The theory specifically excludes any responsibility of a corporation towards society, whose interests are to be guarded by the government, rather than the business sector.

Friedman’s theory has underpinned many of the corporate governance practices developed in the U.S. market over the last 40 years, such as executive compensation related to the company’s performance, shareholder rights and the role of the board of directors. While the Friedman theory is considered a cornerstone of free market capitalism, it has been criticized for promoting short-termism and thereby increasing the risk of shareholder activism, putting upward pressure on executive remuneration and practices such as share buybacks to boost short-term results.

The new purpose of a corporation – what could it mean in practice?

While the BRT’s new statement could mark a sea change for U.S. corporations, it offers scant details on how this new philosophy can be operationalized. However, other recent U.S. forays into sustainable capitalism, such as Senator Elizabeth Warren’s proposed “Accountable Capitalism Act” and the introduction of “benefit corporations” in many jurisdictions, allow us to constructively speculate on the practical implications of the statement.

  • Employee representation on the board of directors. This corporate governance practice has already become the standard in some European markets. Employee representatives on the board would mean direct involvement in high-level strategic decision making, giving employees a voice on issues that impact them.
  • Linking executive remuneration to sustainability metrics. Examples include employee safety, supply chain transparency, and community relations.
  • Increased transparency on key stakeholder interests. This could manifest itself as mandatory corporate social responsibility (“CSR”) reporting for all U.S. companies, either as part of the financial reporting or as a separate filing following standardized templates developed by the regulatory authorities.
  • Restrictions on the use of cash for non-operational activities such as share buybacks. Such uses redirect money from long-term reinvestment in the business, employee benefit programs, and engagement with local communities.

New purpose of a corporation – what’s next?

The fact that the leaders of some of the largest companies in the world have come together and agreed to officially support a shift from shareholder primacy towards an explicit consideration of long-term stakeholder interests, is a significant accomplishment. However, there is a risk that this revolutionary theoretical shift will fail to generate practical results. Although the BRT has clearly stated it does not support radical corporate governance changes derived from the new focus on stakeholders’ interests, changes will likely be needed to make this theory a reality. These issues will likely be discussed and agreed upon within business, academic and regulatory circles in the U.S. When designing any corporate governance changes it will be important to ensure the new principles are put into practice and that clear lines of accountability towards the relevant stakeholders are defined. Means to resolve potential conflicts generated by the company’s responsibility towards several stakeholders instead of only one – the shareholders – will also need to be established.

Despite the challenges, it is extremely important to maintain the momentum that the statement has generated so that it does not just remain a theory without any practical relevance. While drastic and urgent changes can be disruptive, taking constant even if small steps towards making the focus on stakeholders and long-term sustainability of the business a reality seems like the right path to take in the medium to long-term.

 

Sources:

Business Roundtable (August 2019), “Business Roundtable Redefines the Purpose of a Corporation to Promote ‘An Economy That Serves All Americans’,” https://www.businessroundtable.org/business-roundtable-redefines-the-purpose-of-a-corporation-to-promote-an-economy-that-serves-all-americans

Council of Institutional Investors (August 2019), “Council of Institutional Investors Responds to Business Roundtable Statement on Corporate Purpose,” https://www.cii.org/aug19_brt_response

CNBC (August 2019), “The CEOs of nearly 200 companies just said shareholder value is no longer their main objective,” https://www.cnbc.com/2019/08/19/the-ceos-of-nearly-two-hundred-companies-say-shareholder-value-is-no-longer-their-main-objective.html

Harvard Business Review (August 2019), “181 Top CEOs Have Realized Companies Need a Purpose Beyond Profit,” https://hbr.org/2019/08/181-top-ceos-have-realized-companies-need-a-purpose-beyond-profit

Fortune (August 2019), “America’s CEOs Seek a New Purpose for the Corporation,” https://fortune.com/longform/business-roundtable-ceos-corporations-purpose/

Business Roundtable (August 2019), “Redefined Purpose of a Corporation: Welcoming the Debate,” https://medium.com/@BizRoundtable/redefined-purpose-of-a-corporation-welcoming-the-debate-8f03176f7ad8

Triple Pundit (October 2019), “After the Business Roundtable Purpose Statement, a Long Road Ahead,” https://www.triplepundit.com/story/2019/after-business-roundtable-purpose-statement-long-road-ahead/85091

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