Writing in The New York Times Magazine in 1970, Milton Friedman, future Nobel Prize winner and leader of the Chicago school of free market economists, was characteristically blunt about those who claim “that business is not concerned ‘merely’ with profit but also with promoting desirable ‘social’ ends . . . They are — or would be if they or anyone else took them seriously — preaching pure and unadulterated socialism.”
It was an influential article. Friedman argued that the company’s responsibility was “to make as much money as possible” for the owners, “while conforming to the basic rules of society”. This sowed the seed of shareholder value, which later bloomed into a fully formed theory. In practice, it was followed by “Neutron Jack” Welch at General Electric in the 1980s, before it was seized upon by consultants and investment bankers, sold to their clients and implemented in thousands of businesses across the Anglo-American world.
Encouraged by incentive plans and share option schemes that paid out too quickly, corporate executives were willing participants. The fund managers representing shareholders for whose benefit this was supposedly happening fanned the flames by pressing for immediate results that fitted their own quarterly reporting cycles. It became tempting to sacrifice research and development and other long-term investment plans in the interests of pleasing today’s investors and the definition of shareholder value became squeezed and shortened.
For three decades at the end of the 20th and beginning of the 21st centuries, this version swept all before it. Periodically, the animal spirits got out of control and had to be tamed. A crop of scandals in the late 1980s and early 1990s led to the UK’s Corporate Governance Code in 1992. The collapse of the internet bubble in 2000 exposed corporate charlatans in the US and led to the Sarbanes-Oxley Act of 2002. These and other reforms made everyone briefly feel better, but made little difference to the way in which businesses were run.
One reason was that shareholder value appeared to be working as globalisation apparently lifted all boats. It took the banking crisis of 2008 and the ripple effect of financial disaster to expose the flaws of the theory; not least that many of the boats had been left behind. This was evident from a widening pay gap between those at the top and those at the bottom, and — in the UK — stagnant real wages and uncompetitive productivity. The public articulated its discontent in a series of unexpected election results. This led to Donald Trump in the White House, Brexit and a prime minister with a diminished majority in Downing Street.
How the corporate and institutional elite responds is the next big play and there is a way forward for both investors and investee companies. The UK’s Stewardship Code encourages investors to engage with companies “on matters such as strategy, performance, risk, capital structure and corporate governance, including culture and remuneration”. And so they should.
A new Financial Reporting Council consultation paper invites comment on proposals for companies to improve engagement with wider stakeholders, to have regard to wider society and to avoid groupthink. Friedman would be furious but the proposals are specific, sensible and, if acted upon, would do a great deal to heal the wounds. But it is a big if.
The risk is that the box-ticking apparatus will be dusted off, committees formed and the wrong questions asked. This became evident in a recent discussion with a senior British corporate heavyweight who described how governance works at one FTSE 100 company. The board visits key locations, certain sectors are allocated to different board members, regular meetings are held with executive management and there is the full governance panoply. It sounded impressive and reassuring, until I realised that none of it had worked. The business had got into trouble with its shareholders and regulators because none of the right questions had been asked.
To reform, boards need to develop a mindset that challenges rather than seeks to justify the status quo. Broadening board representation as advocated by the proposed code would be a start, but existing board members need not wait for that. The alternative, carrying on as before, has already led to a fractured society and the final result, albeit via a different route to that envisaged by Friedman, could indeed be socialism.