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It is time to usurp the shareholder

07 November 2017

It is time to usurp the shareholder - Read more

A radical rethink of governance is needed to salvage the UK’s economy

Britain is in the middle of the longest stagnation in earnings for 150 years. Young people today are set to be poorer than their parents. We have the richest region in Europe – inner London – but most regions are now poorer than the European average.

Productivity in the second quarter of this year is just 0.9% higher than a decade ago, the worst result for a 10-year cycle for 200 years, while a third of UK companies have seen no rise in productivity since the turn of the millennium.

These are symptoms of deep and longstanding structural economic weaknesses that require bold and systematic reform to address. Reforming corporate governance is one crucial aspect of this.

Britain’s poor performance on productivity and living standards partly stems from how – and in whose interest – British companies are governed. Shareholders have primacy in UK corporate governance.

However, in terms of formal participation and governance rights for employees, the UK comes sixth from bottom among EU countries, ahead of only Bulgaria, Cyprus, Latvia, Lithuania, and Estonia. Our shareholder-centric model appears to contribute to our economic challenges.

IPPR’s analysis of corporate governance systems in the EU28 showed a positive correlation between shareholder-orientated governance systems and poor performance on productivity, business research and development (R&D) expenditure and higher rates of inequality.

For example, only three of the UK’s 168 regions, as defined under the NUTS3 standard, are more productive than the German average, which has a stakeholder model of governance.

The primacy of shareholder interests has contributed to the growth of short-termism in British businesses. As the average length of shareholding has fallen – from six years in the 1950s to six months now – incentives and behaviours between companies, their shareholders and financial intermediaries have become misaligned.

“A modern economy requires productive, purposeful and long-term oriented companies, founded on a partnership between shareholders, management and workers”

This is manifested in a decline in investment and a rise in the proportion of earnings distributed to shareholders, with poor long-term results both for savers and companies themselves.

Between 1990 and 2014, the proportion of discretionary cash flow returned to shareholders (including dividend payments and share buybacks) from UK non-financial corporations increased from 39% to 46%. Only around 25% of finance raised by companies is now spent on investment.

Even as real weekly wages remain below their peak in 2008, the UK model of governance has not curbed a culture of rising executive pay unrelated to company performance.

Over the last 20 years the value of the FTSE 100 has barely risen, while executive pay has increased by more than 400%. Between 2010 and 2015 alone, the average pay of FTSE 100 company directors increased by 47%, while average employee pay rose by just 7%.

Tackling ingrained underperformance in terms of investment and productivity and unequal pay will require more than tinkering. Instead, a fundamental change in how British companies are governed is needed. A modern economy requires productive, purposeful and long-term oriented companies, founded on a partnership between shareholders, management and workers.

Three steps can help achieve this. Firstly, section 172 of the Companies Act 2006 should be reformed to make explicit that the long-term success of a company is the primary concern of its directors. The law should make clear that the shareholders’ interests, while critical, do not necessarily take priority over the interests of employees, or responsibilities to other stakeholders.

Employee representation should be embedded in corporate governance, including elected worker-directors on large company boards and representatives on remuneration committees. At least two members of the board, and preferably a third of the total, should be elected worker-directors, with similar representation on remuneration committees.

To ensure compliance this should be implemented through legislation, although reform of the UK Corporate Governance Code and its application to both listed and private companies is an alternative.

Finally, a companies commission should be established to oversee and strengthen corporate governance standards among both listed and private companies.

An independent regulator with investigative powers and legal remedies would help restore public trust in major businesses. The commission could be either an entirely new body, or build on the Financial Reporting Council which currently oversees the governance code.

Reforming governance will not fix all of Britain’s economic weaknesses. However, rewriting the rules that govern how firms operate is a crucial step towards building a more productive economy that works for everyone.

Mathew Lawrence is a senior research fellow at IPPR, and author of ‘Corporate Governance Reform: Turning business towards long-term success

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