How companies can play the longer game
2 November 2022
Opinion: Once we separate the focus of boards from the interests of current shareholders, companies can better employ environmental, social and governance values to all our benefit, says Susan Watson.
In his book Finite and Infinite Games, James Carse offers a key concept that could be applied to corporate behaviour: “There are at least two kinds of games. One could be called finite, the other infinite. A finite game is played for the purpose of winning, an infinite game for the purpose of continuing the play.”
The purpose of a finite game such as chess or rugby is to win within a fixed set of rules; winners win while losers lose. Through Carse’s lens, company directors operating under the shareholder primacy model have often played a finite game, one that typically involves extracting the maximum value possible at any time for the sole benefit of current shareholders.
This shareholder primacy model, where the company is equated with its shareholders at any time in the same way a partnership is equated with its partners at any time, has dominated corporate behaviour in recent decades, incentivising extreme risk, and often resulting in harm to people and the planet. Those harms are called ‘externalities’, consequences that others must bear – sometimes the environment.
A recent court ruling has the potential to change this; to encourage company directors to play more of an ‘infinite game’. Company directors owe their duties to the company but a recent UK Supreme Court case, the Sequana case, explored the long-contested question in company law of whether the company they owe duties to is composed of its shareholders, or if the company is a separate legal entity from its shareholders.
In New Zealand, s15 of the Companies Act 1993 states that a company is a separate legal entity from its shareholders. However, because of its convoluted history, a paradox of modern company law has always been the contradictory belief that the company is also equated with its shareholders.
It could mean paying employees more which may mean that current shareholders receive a lower dividend in the year ... from which the company benefits economically in the long term.
The UK Supreme Court found that the duties directors owe are to the company as a separate legal entity from its shareholders. While duties are owed to the company, the interests of shareholders who provide the corporate capital that underpins the company are of primary significance.
However, if a company is approaching insolvency, the interests of creditors become more significant. By implication, considering other stakeholder interests is legitimised so long as doing so is in the interests of the company.
The ruling affirmed that shareholders do not own companies, but they have an economic interest in companies. Once we separate the focus of boards from the interests of current shareholders, and the idea that the current shareholders own the company, companies can play more of an ‘infinite game’.
Thinking this way allows companies to keep playing the game in the longer term, meaning that Environmental, Social and Governance aspects become critical considerations. The values underpinning the corporation and its purpose matter as they will potentially outlast any individual human participant.
The ruling suggests decisions can be made that may not be in the interests of current shareholders in the sense that they may reduce profitability in the short-term but may be in the interests of the company which, in theory, could go on forever.
It could mean paying employees more which may mean that current shareholders receive a lower dividend in the year, but by adopting an infinite perspective, the higher wages may ensure the employees are retained by the company and also develop trust and loyalty to the company, from which the company benefits economically in the long term.
When an infinite perspective is adopted, taking care of the interests of all stakeholders, such as employees as participants in the game, ultimately enhances the interests of the company.
It could also mean making decisions that are positive for the environment even if this decision may cost the company and reduce profitability in the short term. However, taking care of the environment may protect the company from being regulated, enhance its reputation and customer base, and therefore its value. Moreover, future generations are protected, because no one will win if our environment cannot sustain human life.
Good evidence exists that looking beyond maximising short-term profitability for current shareholders will help companies endure, as evidenced by Quaker companies such as Cadbury and Lever Brothers. Cadbury focused on taking care of its workers to the extent that it built a model village to house them – Bournville. Lever Brothers built Port Sunlight. Notably a number of those Quaker companies still exist in some form today, including Cadbury, and Lever Brothers, which became Unilever.
Boards often do make decisions adopting a perspective that recognises that share value is based on a market’s understanding of the potential long-term value of a company as much as short-term profitability reflected in dividend pay-outs. Directors who believe they are operating within the shareholder primacy paradigm rationalise these decisions by saying they are thinking about future shareholders. But if a company is based on its shareholders at any time, why should directors care about future shareholders ahead of current shareholders?
A better rationalisation that aligns with the company being a separate legal entity from its shareholders is simply for directors to say that they are acting in the interests of the company. That is not to say the interests of corporate stakeholders override the interests of shareholders whose corporate capital underpins the company. It is because when an infinite perspective is adopted, taking care of the interests of all stakeholders, such as employees as participants in the game, ultimately enhances the interests of the company.
There are limits to the discretion of directors. The purpose of the game is to keep playing the game and to grow the value of the company over time. It is not legitimate to serve the interests of stakeholders to the extent that the capital base of the company is eroded and the company is no longer solvent. That would mean the game must end.
Companies that stay in the game and endure, enrich their shareholders over time.
Investment company Vanguard Australia tracks how an initial investment of $10,000 in US shares in 1992 would have grown to a staggering $182,000 by August 2022. This far exceeds even the recognised magic of compound interest. In the same period, $10,000 invested on compounded term deposits would have grown to $38,000.
The modern corporation has undeniably lifted the average living standards of populations across the world. As the primary tool of capitalism, the corporation can be used to create value from ideas for the benefit of all by providing goods and services that people need or want, as seen with the Covid vaccine rollout.
But corporations can extract value from people and the planet to the extent they cause harm for which they are often not held accountable. In other words, the economic benefit is often shared unequally, contributing to inequality.
Yuval Noah Harari, the author of Sapiens, described companies as “amongst mankind’s greatest inventions”.
The key may be the potential longevity of the corporate form. Fuelled by the capital provided by shareholders, a company as a separate legal entity can operate in the world as an artificial legal person transcending current shareholders, and potentially exist forever.
Recognising the implications of the finding that companies are separate legal entities from shareholders extends the horizon for corporate decision makers in a way that enables them to incorporate values and Environmental, Social and Governance aspects in a principled way while ensuring the company endures.
Professor Susan Watson is Dean of the Business School. She holds joint chairs in the Faculty of Law and Faculty of Business and Economics at the University of Auckland, and author of The Making of the Modern Company (2022).
This article reflects the opinion of the author and not necessarily the University of Auckland|Waipapa Taumata Rau.
First published in Newsroom, How companies can play the longer game, 1 November 2022.
Margo White I Media adviser
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