Directors Duties towards Shareholders and Stakeholders - Essay Example

Director's duties towards shareholders and stakeholders. Profit maximization has been traditionally accepted as the singular and most significant objective of an enterprise. The shareholders are the indisputable owners of the company, therefore the directors' duty towards them is considered paramount. The implication is that the directors must strive to maximize the value of shareholdings. However, in recent years the idea of corporate social responsibility has gained much ground. Corporate social responsibility (CSR) is a "concept that suggests that commercial corporations have a duty towards all of their stakeholders in all aspects of business operations. These can include (but may not be limited to) employees, customers, suppliers, community oraganaizations, local neighborhood and shareholders.'-Wikipedia.CSR entails that corporations should contemplate the actual and impending effects of their decisions on other stakeholders as well. It is correlated with the principles of sustainable development, which propagate that social, environmental and other consequence of business decisions should be taken into consideration. These two aspects can be better understood by examining the shareholders and stakeholders theories. The main ideas of the two theories are juxtaposed under the following heads. Director's fiduciary duties: The Shareholder's theory advocates that value maximization should be the governing corporate objective. It makes a plea that the interest of the shareholders should precede over that of other constituents, based on the presumptions of capitalism. The supporting view is that, the directors fiduciary duty is to run the company in the interest of the shareholders.Tradional property rights are cited as a justification for this argument. The shareholders are the owners of the company, therefore they hold property rights. Sternberg points out, "What using business resources for non business purposes actually is, is theft, an unjustified appropriation of owner's property"-(Sternberg 1997:82) .Another validation for this argument is given by the principal-agent relationship between the directors and shareholders. The directors in the capacity of agents are liable to act in best interest of their principals, therefore strive for profit maximization. The chief proponents of the stakeholders' theory are Donaldson and Preston. According to this school of thought, directors should have multi fiduciary duties towards all the stakeholders. Stakeholders are the people who affect and are affected by the company. The stakeholders view of strategy is an instrumental theory of the corporatin, integrating both the resource based view and the market based view, it is opposed to the view where the company solely tries to increase the value for shareholding. The stakeholder group should not be treated as a mean to some end but must be participative in detreming the direction of the company in which they hold stake. Basis for determining business relationships: As per the shareholders' theory, business relationships are determined by legal contracts. Thus, it recognizes accountability towards those parties with whom explicit legal contacts have been signed. It follows Sternberg's argument that such contracts are made under 'libertarian free contracting". This vastly limits the scope of the corporation's obligations. On the other hand, the stakeholders' model advocates social and moral obligations towards all those who affect or get affected by the company, these obligations may be become binding on the company via legal or implied contracts. Both the theories accept that the firm is a nexus of contacts but differ about the basis for determing those contacts. Objective of wealth creation: The two theories take different stands about the nature of these contracts. Kay's work in strategic management (Kay1993), show that managing contracts on collaborative, 'relational' basis can lead to competitive advantages directly benefiting shareholders. Thus, shareholder's theory acknowledges that contacts should be favorably managed, beyond duty not to harm but does not encompass multi-fiduciary duties. Increase in the value of shareholding is accepted as the primary objective of the corporation in the shareholder's theory. It is argued that value maximization will result in greater wealth creation. The other school of thought takes a broader view and incorporates social welfare. It propagates the idea of 'higher social returns'. Generation of wealth should go hand in hand with fairer distribution of wealth that will result in genral social welfare.A company must participate in the economic and social life of the community and ensure social returns to the stakeholders on ecological principles.So,whereas the shareholders theory ensures satisfaction, the stakeholders theory demands 'more than satisfaction'. Applicability of stakeholders' theory. After evaluating the claims of the two theories, I reckon that the practice of corporate social responsibility can go hand in hand with competitiveness and profitability. Short term goals of a company should not be detrimental to sustainable development.Managment should devise and pursue strategies that increase shareholder's value and support stakeholders' interest as well, to resolve the conflict of interest between the two groups. No company can operate without employees,suppliers,customers.David Norton, company group chairman Johnson and Johnson, claimed that his firm had been following CSR practices for the past twenty five years and that the shareholders earned a great return over that period of time.(FT mandate) Stakeholder controlled enterprises around the town of Mondragon in the Basque area of Spain, is a case in point. A World Bank study reported that: 'During more than two decades a considerable number of cooperative factories have functioned at a level equal to or superior in efficiency than that of capitalist enterprises. The compatibility question in this case has been solved without doubt.Efficency in terms of the use made of scarce resources has been higher in cooperatives, their growth record in sales, exports and employments under both favorable and adverse economic conditions, has been superior to that of capitalist enterprises" The Mondragons forms adopted a new model for governance based upon decentralized communication.Dr Shann Turnbull,in his paper 'Increasing profits with CSR'suggets the introduction of the concept of 'network governance' in companies. Operating advantages attained by the Montdragon firms could act as an incentive for the shareholders to vote for such a change. He further suggested-regulation and that government laws should be relaxed so that the cost of regulation can be reduced. This could result in reduction in compliance cost while ensuring stakeholders protection. While this observation has been based upon empirical evidence, it can said to be antagonistic towards the free-market ideology. The implementation of the model suggested by Turnbull,is questionable Therefore while it might have generated benefits in Spain, where it was devised to provide a solution to chronic unemployement,it's applicability in other markets and regions maybe limited. Can value maximization be the governing corporate objective If profitability and value maximization were adopted as the governing corporate objectives, what implication would this strategy have on other stakeholders It would be worthwhile to study the case of Enron here. This is the case of America's largest corporate bankruptcy, a fraud of epic proportions. It slid from the position of the seventh largest corporation in US to liquidation, a scandalizing comedown. The chief reason for its devastation, if there could be one, was greed and corporate arrogance. The key players in the management got so avaricious; they did not realize that they were drowning their own lifeboat. It is noteworthy, that while the profits of the company spiralled, the rights and interests of the stakeholders were shockingly violated. Jeff Skilling, Enron chief executive had been known to believe that so long, the value of shareholding increased, any means to that end were acceptable. This obviously was a very dangerous and fundamentally flawed line of thought. Whereas Enron's case is an example of unwarranted infringement of stakeholders' rights, it shows that even profitability of an enterprise cannot be sustained if stakeholders are disregarded, and policies, which were detrimental to their interest eventually, brought about its downfall. In what ways were the stockholder's interests subverted at Enron Skilling introduced the performance review committee (PRC) for measuring the efficiency of employees. The basis for measuring performances, theoretically were the values of Enron-respect, integrity, communication, execellence (RICE), but actually it was the profit figures posted by the employees. This caused fierce internal competiton, short term gains super ceded the long-term goal of sustainable development. Restrictive confidentiality clauses increased in trade agreements. Financial deals were made in haste often overlooking the strategic rules of the organization. Lack of transparency and disclosure perpetrated the accounting malpractices. On subsequent investigation it was discovered that the auditors, accountants, bankers were all hand in glove with the corrupt executives. Outside investors including financial institutions were misinformed about the company net income, losses and liabilities were understated. The auditor Arthur Anderson was later indicted on obstruction of justice charges. Financial analysts' believed the integrity of the financial statements that were tampered with therefore erroneous.Merill Lynch fired the only analyst who asked questions. In 1999, Enron's board waived the conflict of interest rules to allow CFO Andrew Fastow to create private partnerships to do business with the organization. Transactions between these parties involved concealing debts and losses, which had they been reflected in the books would have considerably affected the profits. Enron's collapse also raises questions about the directors' oversight in safeguarding the interests of the stakeholders, in this case. Enron accounting firm also suffered as its offences were established later.29000 employees lost their jobs. Retirement accounts of Enron's rank and file workers were frozen. The employees were misled and continued buying stocks whereas the key executives had started unloading heavily mush before the liquidation. Tinged stockholders theory: An Integration of ideas Both theories offer well-grounded arguments to support their claims. The inference drawn from the above case studies is, that the implementation of stakeholders theory calls for structural changes, network governance as demonstrated in the Mondragon's example. If the stakeholder's theory could illustrate that, not only did it give rise to greater levels of satisfaction to the non-shareholders but also lead to better conventional corporate performance (so that the shareholders would be better off as well) it could legitimately claim to be superior. However, the evidence in this respect is limited. Whereas the shareholders theory with its overriding importance to profitability, as apparent in the case of Enron, compels one to reconsider priorities and policies. Tinged stockholders theory offers reconciliation between the conflicting schools of thought.Langtry concludes the main idea of the stockholder (shareholder) theory as: ".avoids objections that has been raised to pure stockholder theory and is consistent with Kantian or contraction foundations for morality. Tinged stockholder theory can generate rich amounts of moral duty, moral virtue and morally attractive community life in business."Langtry (1994,p-441) Therefore, it integrates the main ideas contained in two theories. It has an instrumental approach to stakeholding, allows for social obligations while retaining the fiduciary duties of the directors and therefore their accountability towards the shareholders also. Closing Thoughts. There is no doubt about the fact the interest of the shareholders should be maintained, however the non-shareholding parties should not be disregarded. Solely pursuing profits would adversely affect the the sustainability of the organization. The two goals are not irreconcilable and cab be assimilated, as offered by the tinged stockholders theory.CSR should be included in the broad framework of an enterprise while aiming for profits. References 1. http://en.wikipedia.org/wiki/Corporate_social_responsibility 2. Business Ethics; A European Review, Geoff Moore (1999) Vol 2. 3. www.ftmandate.com 4. Transcription of the film Enron: The Smartest Guys in the room presented by HDNET films 5. Langtry, B.1994. 'Stakeholders and moral responsibility of business. 'Business Ethics Quatrely.p-441 6.*Henry Thornton - Increasing profits with Corporate Social Responsibility.htm PS:*I cant seem to retrieve this link, I will send it through the message board very soon. Read More