Corporate Social Responsibility from the Progressive Era to the Banking Royal Commission

After a tumultuous year our banks are back in the spotlight. When several of the Big Four banks failed to pass on the recent interest rate cut in full, Treasurer Frydenberg accused them of failing to learn the lessons of the Banking Royal Commission (Commission), raising the spectre of “profits before people”.

Such discourse isn’t new. But it is definitely trending upwards. It’s a widely held belief that modern companies are untrustworthy, tending to “focus on their own agendas rather than wider society“.

If we cannot trust businesses to think outside the interests of their directors and shareholders on their own initiative, should our laws change to mandate consideration of people and communities? Does the success of our corporations really have to be at the expense of our people?

Must social responsibility temper economic success?

A few years ago, Michael Porter and Mark Kramer wrote in the Harvard Business Review that business and society have been in conflict “too long … because economists have legitimised the idea that to provide societal benefits, companies must temper their economic success”.

Worldwide there is perhaps no greater modern illustration of the result of this supposed ideological dichotomy than our own Banking Royal Commission.

The Commission spent 2018 chipping away at misconduct in board and meeting rooms, grimly exposing the systemic failure of boards to improve corporate governance.

Commissioner Hayne wrote in the Interim Report that “… pursuit of profit has trumped consideration of how the profit is made. The banks have gone to the edge of what is permitted, and too often beyond that limit, in pursuit of profit“.

A remarkable consequence of the Commission’s work has been the elevation of substantive public discussion about corporate governance – a subject that can only be described as nominally of niche public interest (sorry, corporate lawyers). The ASX Corporate Governance Council’s most recent Corporate Governance Principles and Recommendations reveal a uniquely post-Commission tension between considerations of short-term economic success and the long-term viability of the company.

Momentarily capturing the spotlight during the Commission was one frank admission by a bank chairman that director’s duties should be expanded to include “the community“, potentially also “the future community“, adding that “boards should understand…that their responsibilities to the community go beyond their obvious responsibility to shareholders“. Cue… faint.

While attractively simple, this statement doesn’t tackle the legally-trained elephant in the room. Mandating changes to directors’ duties doesn’t address the solely shareholder-driven mentality persistent in many boardrooms that steered us maddeningly towards the Commission. Like cultural cringe and anomalous grammar, this ideology reaches its tendrils here from across the Pacific  – but it didn’t have to be this way.

Dominant theory of the firm: shareholder über alles

You may wonder how in 2019 we wound up again discussing whether there’s a “right way” for corporations to pursue profit.

The answer to how we got to this point lies partly in the dusty excesses of academia in the 1970s. In 1976, Michael Jensen and William Meckling published the seminal work of the now dominant theory of corporate governance – Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. According to Jensen and Meckling, the firm is a “legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals are brought into equilibrium within a framework of contractual relations“.

Given the firm is “not an individual“, questions such as “does the firm have a social responsibility?” are inappropriate and even “misleading“. Under this view, corporations simply cannot have a corporate social responsibility. The Jensen and Meckling theory categorically rejects the idea of stakeholders other than the company’s shareholders (employees, community, or the environment, for example) impacting the deliberations and considerations of boards exercising their powers.

The theory is dominant because it is the prevailing personal view of a significant proportion of directors (for instance, in the superannuation funds industry where decision makers ascribe too much value to short-run performance over members’ interests). This is a problematic approach to business because the logical endgame of Jensen and Meckling theory is the kind of short-termism and shareholder über alles misconduct revealed at the Commission. If you can’t have a responsibility to stakeholders, why bother considering them at all?

At the tail end of the progressive era (late 1800s to the early 1900s) there was a very different viewpoint on the theory of the firm bouncing around in the manufacturing yards and courtrooms of an unlikely place: Michigan.

Early director-driven stakeholder integration

One hundred years ago, the Michigan Supreme Court handed down the final decision in Dodge v Ford Motor Company, 170 N. W. 668 (Mich Sup Ct, 1919) (Dodge). The law in Dodge is one of the clearest early statements of shareholder primacy – the case is interesting because it’s a microcosm of social issues occurring in the early 20th century and echoing through ours.

In the early 1900s, unrestrained capitalism suddenly had an alternate, contrasting (and, to the man on the Bondi tram gazing at the nouveau riche glitterati, attractive) version of economics and social dynamics with which to contend: socialism.

The dominant idea then – just as now – was that the American corporation shouldn’t have to account for anything but short-term wealth maximisation.

Enter Henry Ford. Ford withheld money generated by Ford Motor Company (FMC) for the purposes of increasing production, hiring more workers, and paying staff above market. The Dodge brothers, minor shareholders in FMC, sought payment of part of the money as a dividend. Ford wanted ultimate control over the funds.

In the Circuit Court, Ford pronounced the manifesto of FMC: “[FMC is] organised to do as much good as we can, everywhere, for everybody concerned. And incidentally to make money. ” This statement from Ford’s heart… just kidding. While it’s a pleasant fantasy to instill modern values onto arch-capitalist Ford this proclamation was likely, as they say, fake news.

Ford realised that by paying FMC workers far above average industry wage he could attract more people, acquire most or all of the skilled automotive manufacturing workers, and deter unionisation among them. By doing so, FMC could generate goodwill in its stakeholder communities, out-spend smaller competition in the short term, produce more for the market at (eventually) lower cost and, over time, maximise FMC’s total return.

Given the ideological background to this legal stoush, in the denouement, the Dodge brothers came up trumps – with the Michigan Supreme Court holding: “it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of shareholders and for the primary purpose of benefiting others“.

While it’s correct to doubt the motivation behind Ford’s proclamation, he affected genuine consideration of his business’s stakeholders – especially the wellbeing of his employees. The Dodge case, and Ford and FMC generally, is illustrative that the short-term exclusively shareholder driven model that so captivates modern directors is not the only way to ruthlessly pursue profit or to be successful at doing so. It does, however, require a strategy longer than the next shareholders meeting.

Will changing modern directors’ duties shift corporate culture?

Arguably, the law is too blunt an instrument through which to orchestrate systematic and lasting ideological changes in companies or directors (or people generally, really).

While companies and directors may look forward to the increasing exercise of coercive power being used to hold them accountable to stakeholders after the Banking Royal Commission, if what we’ve seen in the United Kingdom over the past decade is anything to go by, changing directors duties to include considerations of stakeholders and community by itself is simply not enough.

For a few years now, directors in the United Kingdom are supposed to have been acting in “good faith” to “promote the success of the company“, having regard to:

(a) the likely consequences of any decision in the long term,

(b) the interests of the company’s employees,

(c) the need to foster the company’s business relationships with suppliers, customers and others,

(d) the impact of the company’s operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business conduct, and

(f) the need to act fairly as between members of the company

(Companies Act 2006 (UK), s 172(1)).

Trouble is, it hasn’t exactly worked. While s 172 “gives the illusion to the business community, regulators, certain scholars, and market players alike, that something is being done in the sphere of company law in relation to acknowledging stakeholders’ interests in corporate decision-making… this is far from being the case“.

At home, directors are currently bound to exercise their powers in “good faith in the best interests of the corporation” (Corporations Act 2001 (Cth), s 181(1)). The only qualifier to this statement is “for a proper purpose” (s 181(1)(b)). This requirement is commonly understood to mean to act in the best interests of shareholders.

Our legislative framework currently already allows directors to consider stakeholders (such as the community) at their sole discretion, but it does not mandate that they do so. Section 181 is an expression of the Jensen and Meckling view of the corporation. While it is certainly unfair to say that our law mandates strict profit maximisation, it is not without merit to argue that it does not discourage it all that much either.

If arch-capitalists like Ford can see corporate gain over the longer term, sometimes but not invariably at the expense of the happiness of shareholders, maybe it’s time our banking executives and corporate directors opened a history book. And maybe that’s where we’ll find our answers too.

Alexander Ross is a Sydney-based lawyer working with the knowledge team at King & Wood Mallesons. Prior to KWM he worked for Thomson Reuters’ own Practical Law, as an associate in restructuring and insolvency at Squire Patton Boggs and at a NewLaw startup.

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