Here is an excerpt from an article written by Joseph L. Bower and Lynn S. Paine for Harvard Business Review and the HBR Blog Network. To read the complete article, check out the wealth of free resources, obtain subscription information, and receive HBR email alerts, please click here.
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A better model, we submit, would have at its core the health of the enterprise rather than near-term returns to its shareholders. Such a model would start by recognizing that corporations are independent entities endowed by law with the potential for indefinite life. With the right leadership, they can be managed to serve markets and society over long periods of time. Agency theory largely ignores these distinctive and socially valuable features of the corporation, and the associated challenges of managing for the long term, on the grounds that corporations are “legal fictions.” In their seminal 1976 article, Jensen and Meckling warn against “falling into the trap” of asking what a company’s objective should be or whether the company has a social responsibility. Such questions, they argue, mistakenly imply that a corporation is an “individual” rather than merely a convenient legal construct. In a similar vein, Friedman asserts that it cannot have responsibilities because it is an “artificial person.”
Shareholders’ gains are sometimes simply transfers from the public purse.
In fact, of course, corporations are legal constructs, but that in no way makes them artificial. They are economic and social organisms whose creation is authorized by governments to accomplish objectives that cannot be achieved by more-limited organizational forms such as partnerships and proprietorships. Their nearly 400-year history of development speaks to the important role they play in society. Originally a corporation’s objectives were set in its charter—build and operate a canal, for example—but eventually the form became generic so that corporations could be used to accomplish a wide variety of objectives chosen by their management and governing bodies. As their scale and scope grew, so did their power. The choices made by corporate decision makers today can transform societies and touch the lives of millions, if not billions, of people across the globe.
The model we envision would acknowledge the realities of managing these organizations over time and would be responsive to the needs of all shareholders—not just those who are most vocal at a given moment. Here we offer eight propositions that together provide a radically different and, we believe, more realistic foundation for corporate governance and shareholder engagement.
[Here are four of eight core principles.]
1. Corporations are complex organizations whose effective functioning depends on talented leaders and managers.
The success of a leader has more to do with intrinsic motivation, skills, capabilities, and character than with whether his or her pay is tied to shareholder returns. If leaders are poorly equipped for the job, giving them more “skin in the game” will not improve the situation and may even make it worse. (Part of the problem with equity-based pay is that it conflates executive skill and luck.) The challenges of corporate leadership—crafting strategy, building a strong organization, developing and motivating talented executives, and allocating resources among the corporation’s various businesses for present and future returns—are significant. In focusing on incentives as the key to ensuring effective leadership, agency theory diminishes these challenges and the importance of developing individuals who can meet them.
2. Corporations can prosper over the long term only if they’re able to learn, adapt, and regularly transform themselves.
In some industries today, companies may need reinvention every five years to keep up with changes in markets, competition, or technology. Changes of this sort, already difficult, are made more so by the idea that management is about assigning individuals fixed decision rights, giving them clear goals, offering them incentives to achieve those goals, and then paying them (or not) depending on whether the goals are met. This approach presupposes a degree of predictability, hierarchy, and task independence that is rare in today’s organizations. Most tasks involve cooperation across organizational lines, making it difficult to establish clear links between individual contributions and specific outcomes.
3. Corporations perform many functions in society.
One of them is providing investment opportunities and generating wealth, but corporations also produce goods and services, provide employment, develop technologies, pay taxes, and make other contributions to the communities in which they operate. Singling out any one of these as “the purpose of the corporation” may say more about the commentator than about the corporation. Agency economists, it seems, gravitate toward maximizing shareholder wealth as the central purpose. Marketers tend to favor serving customers. Engineers lean toward innovation and excellence in product performance. From a societal perspective, the most important feature of the corporation may be that it performs all these functions simultaneously over time. As a historical matter, the original purpose of the corporation—reflected in debates about limited liability and general incorporation statutes—was to facilitate economic growth by enabling projects that required large-scale, long-term investment.
4. Corporations have differing objectives and differing strategies for achieving them.
The purpose of the (generic) corporation from a societal perspective is not the same as the purpose of a (particular) corporation as seen by its founders, managers, or governing authorities. Just as the purposes and strategies of individual companies vary widely, so must their performance measures. Moreover, companies’ strategies are almost always in transition as markets change. An overemphasis on TSR for assessing and comparing corporate performance can distort the allocation of resources and undermine a company’s ability to deliver on its chosen strategy.
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Here is a direct link to the complete article.
Joseph L. Bower is the Donald Kirk David Professor Emeritus at Harvard Business School, and co-author of the HBR article “Global Capitalism at Risk: What Are You Doing About It” and the book Capitalism at Risk: Rethinking the Role of Business (Harvard Business Review Press, 2011).
Lynn S. Paine is the John G. McLean Professor of Business Administration at Harvard Business School. She is a coauthor of Capitalism at Risk: Rethinking the Role of Business (Harvard Business Review Press, 2011).