Shareholder primacy already requires directors to actively consider non-shareholder interests

The debate with a false premise and the downside of law reform

Introduction

During the Banking Royal Commission, outgoing NAB chairman Ken Henry said directors should understand 'their responsibilities to the community go beyond their obvious responsibilities for shareholders'.

That sparked a flurry of commentary suggesting Dr Henry's remarks reflected a drastic shift in the existing 'shareholder primacy' approach, an interpretation dependent on the assumption that shareholder primacy requires directors to act solely in the interests of shareholders because the interests of shareholders and other stakeholders are necessarily in conflict.

More recently, on 19 August 2019, the US Business Roundtable released a revised 'Statement on the Purpose of a Corporation', with the Roundtable's 181 CEO members (who represent some of the biggest companies in America) saying they 'share a fundamental commitment to all our stakeholders'.

The Statement has been widely, but incorrectly, labelled as a 'radical change to the mantra of corporate America'. 1 In reality, the Statement is nothing more than a distraction. In Australia, it has been used to give further impetus to calls for legislative change to reflect what is now falsely perceived to be a global movement away from prioritising shareholders and profits.

The debate about shareholder primacy and law reform is now somehow seen as urgent, fuelled by daily headlines and social media posts designed to capture attention and feed off the heightened community sensitivities that remain following the Banking Royal Commission. Yet behind the bluster lies a debate with an entirely false premise and misunderstanding of the existing law in Australia and what shareholder primacy actually means. While shareholder primacy is the standard that informs directors' duty to act in the best interests of the company, it is a mistake to infer that, necessarily, the interests of shareholders and 'other stakeholders' are automatically in competition.

By 'other stakeholders', we mean not only a company's contractual stakeholders, such as creditors, suppliers, employees and customers, but also the wider 'public interest', itself representing a broad range of environmental and social concerns relevant to the community in which a company operates and which may be impacted, positively or negatively, by a company's activities.

Far from being in competition, in the current post-Banking Royal Commission climate of public mistrust and heavy scrutiny of the actions of corporate officers, along with lower consumer confidence in a slowing economy with an uncertain future global outlook, the interests of shareholders and other stakeholders will very often be aligned.

If directors fail to actively consider the interests of other stakeholders, both in pursuing general corporate social responsibility (CSR) measures designed to enhance a company's reputation as a respected, trusted and responsible 'corporate citizen', in addition to identifying and responding to the direct costs to the company arising from various environmental, social and governance (ESG) market risks that specifically impact its operations, the company's profits will inevitably take a hit as investors, customers, employees and suppliers take their business elsewhere. As a result, directors will prejudice the interests of shareholders and breach their duty to act in the best interests of the company.

Yet, on the current formulation of directors' duties in Australia, there will still come a point at which directors may genuinely take the view, exercising their business judgment and the broad discretion the law affords them, that:

any further investment in CSR measures will not on a cost-benefit analysis continue to increase profits as a function of enhanced corporate reputation; and the company has already implemented sufficient measures to mitigate the ESG risks specifically affecting it so that further ESG investment is also not necessary. Once that point is reached, the profit-making objective must take priority and in that sense the interests of shareholders will 'win out' over other stakeholders.

The possibility of divergence between the interests of shareholders and other corporate stakeholders in these cases might then be used to support a call for legislative change to the current formulation of directors' duties in Australia after all.

However, in our view, that would be a reactive and short-sighted response to what has been an emotive public debate. In saying that, we are not suggesting the end of protecting the interests of stakeholders potentially vulnerable to instances of corporate misconduct is not valid. Rather, our argument is simply that reformulating directors' duties is not the most efficient means of achieving that end.

If further protection of other stakeholder interests is desired, it should be achieved by enacting specifically tailored, mandatory environmental, labour and consumer laws, so that directors must ensure the company complies with those laws as a direct cost in its unique ESG risk profile. Increasing the scope of directors' personal liability through expanded duties would have a paralytic effect on directors' willingness to take risks and pursue innovative, value-creating activities, an outcome that would reduce corporate returns and growth to the detriment of not only shareholders but also the very 'other stakeholder' interests intended to be protected by legislative change.

The Shareholder Primacy Model

In his 1970 essay, Milton Friedman, with reference to his earlier book Capitalism and Freedom, rejected the idea of the company as a 'social enterprise' existing to serve the interests of a broad range of community stakeholders, instead positing that:

there is one and only one social responsibility of business - to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, [it] engages in open and free competition without deception or fraud.2 Friedman's expression of what has come to be known as the shareholder primacy model in turn reflects one of the traditional conceptions of the company, as a matter of corporate law theory, as a 'nexus of contracts' between private individuals, in contrast to broader 'communitarian' approaches which view the company as an instrument of social policy capable of being used to satisfy diverse public obligations.3 On that 'contractarian' view, recognition of the company as a separate legal entity supported by limited liability, while in one sense representing a 'concession of the state', is more fundamentally justified by economic efficiency.

To What Extent is Shareholder Primacy Part of Australian Law?

In Australia, directors owe a duty both at general law and under section 181(1)(a) of the Corporations Act 2001 (Cth) (Corporations Act) to act in good faith in the best interests of the company.

Provided a company remains solvent, 'the company' has been interpreted by courts to mean the company's shareholders collectively.4 As Ward J (as she then was) said in International Swimwear Logistics Ltd v Australian Swimwear Company Pty Ltd (International Swimwear):

The consideration as to whether directors have complied with their duties involves determination of whether the conduct diverged from the interests of the company's shareholders (often referred to as 'the shareholder primacy norm').5 Thus, 'the company' does not mean the company as a commercial entity distinct from its shareholders.6 Although some decisions reflect a willingness to allow directors to engage in 'defensive tactics' to preserve the existence of a company subject to a takeover offer,7 those decisions are best viewed not as examples of treating the company as a commercial entity but rather as permitting directors to, in acting in the best interests of shareholders, balance short-term gain (for example by shareholders receiving a price premium for their shares during a takeover) with long-term benefits that would accrue to outweigh any such gain.

With one exception, 'the company' also does not mean any corporate stakeholders other than shareholders. That exception occurs when a company is insolvent, or is at least in an 'insolvency context', at which point the company is properly seen to reflect the interests of creditors, being those who have the first claim to the distribution of whatever remains of the company's property.8 Nevertheless, in this case, directors do not owe an independent duty to creditors, in the sense that creditors do not have a right to pursue proceedings in their own name against directors for any alleged breach of the duty to act in the best interests of the company. Rather, the duty is an 'imperfect obligation' only enforceable by a liquidator on the company's behalf.9

Accordingly, provided a company remains solvent, the shareholder primacy model accurately describes what is currently expected of directors in Australia. It is a critical mistake, however, to assume that the correlation between 'the company' and shareholders means that other stakeholder interests are, ipso facto, irrelevant and can be ignored by directors. For the reasons...