Governance of corporations: Long-term approach vs. short-term approach

A company has been compared to a human body and has been considered to have a brain and nerve centre by Lord Denning in his classic decision in HL Bolton Engineering Co versus TJ Graham & Sons. It is the board of directors who are the directing mind and brain of the company. These observations of Lord Denning have been reaffirmed by the Supreme Court in Sunil Bharti Mittal vs. Central Bureau of Investigation case. The larger question is while running the company, who are the board of directors accountable to and for whom are they supposed to act for? In a classical sense, this is what we call the governance debate.

Broadly speaking there are two models of governance—the shareholder model and the stakeholder model. The shareholder model advocates that a corporation or a company is to be run by the board of directors in a manner to fulfil the interests of shareholders with an attempt at profit maximisation and governance strategies are to be aligned accordingly. The stakeholder model, on the other hand, believes that a company has a social function to perform, apart from making profits and, therefore, should be accountable to not only to its shareholders but also to a wider group of stakeholders, including its creditors, employees, state and national governments and the public at large. Advocacy for this model has resulted in laws relating to corporate social responsibility and thresholds for minimum environmental compliance by corporations.

Dodge vs. Ford Motor Co remains a classic decision surrounding the governance debate. The price of the cars of Ford Motor Co were lowered significantly to ensure that the cars were sold among larger sections of society, resulting in a compromise on profits and, thereby, compromising on the dividends payable to its shareholders. This decision was challenged by its shareholders. It was held that, “a business corporation is organised and carried on primarily for the profit of the stockholders” and, therefore, the board of directors are not supposed to run the company with the purpose of benefiting other stakeholders other than shareholders. This decision clearly established shareholder primacy in the governance debate.

Globally, however, there has been a recent call for change from focusing on the short-term profit maximisation governance strategy to a long-term value-based governance strategy. The Investor Stewardship Group, which is a collective body of some of the largest U.S.-based institutional investors and global asset managers, has recently come out with corporate governance principles with one of them being that the board of directors should identify long-term performance goals that are aligned with the company’s long-term growth strategy, which thereafter are required to be inserted into the management incentive plans. These long-term goals and strategy after their identification should be communicated to the shareholders and demonstrate a close nexus with the model of establishing a corporation focused on sustainable economic value creation.

Similarly, BlackRock, a renowned investment firm in its 2018 priorities of engaging with a corporation has emphasised a need of corporate strategy for the long term. In Larry Frank’s annual letter to CEOs, it has been mentioned that, “The statement of long-term strategy is essential to understanding a company’s actions and policies, its preparation for potential challenges, and the context of its shorter-term decisions. Your company’s strategy must articulate a path to achieve financial performance. To sustain that performance, however, you must also understand the societal impact of your business as well as the ways that broad, structural trends – from slow wage growth to rising automation to climate change – affect your potential for growth.”

Similarly, the Uday Kotak-headed committee, while emphasising the need of corporate governance reforms, mentioned that currently there is an obsessive focus on short-term performance often at the cost of long-term performance. They further go on to say: “Rather than pursuing long-term strategies, many public companies and boards dedicate significant resources to meeting quarterly earnings guidance and communicating their performance relative to this guidance.”

The Kotak committee strongly felt that a focus on the long-term strategy by the boards is necessary to enable our companies shape a strong governance structure for the future and tackle upcoming risks. It has been observed that, “the Committee believes that well-governed companies need to fulfil two major roles: the first to focus on long-term value creation and the second to protect shareholders interests by applying proper care, skills and diligence to business decisions.” Keeping in mind this objective, the Kotak Committee went on to emphasise the need to ensure that there is a right composition of functional and domain expertise at the board level, independence of board of non-executive directors clearly emphasising that independent boards are central to coming out with effective corporate governance mechanisms.

It has been further emphasised by the Kotak committee that long-term aspects of corporate governance such as strategy, succession planning, budgets, risk management, ESG (environment, sustainability and governance) and board evaluation are taken up by the board at least on an annual basis and medium-term and long-term strategy should be disclosed by the companies in their annual reports.

The discussions above clearly indicate that there is a gradual shift globally as well as in India towards a corporate governance model focused on long-term sustainable value creation, rather than mere fulfilment of the short-term agenda of profit maximisation. A company which adopts a long-term strategy of corporate governance is more likely and better-placed to attract global investors in the current times.

Atul Pandey is partner and Satish Padhi is senior associate at Khaitan & Co. Views are personal.