Well-run Businesses Are Essential For A Healthy Economy

18/07/2017 11:03 BST | Updated 18/07/2017 11:03 BST

If the Prime Minister is still rooting around for policy ideas, she should reconsider one of her own. When she first stood on the steps of Downing Street, she promised to change how businesses were run to the benefit of ordinary workers. Yet corporate governance reform was ditched from the Queen's Speech. However, with all the major parties having committed to reform during the general election, there is a Parliamentary majority to deliver bold action. Now is the time then to fulfil her pledge to reshape how our companies operate.

Corporate governance is about how companies are run and in whose interest. It defines the constitution of the firm: how rights and reward are distributed between stakeholders in the governance of an enterprise. Crucially, Britain's poor performance on investment, productivity and inequality stem in part from how - and in whose interest - British companies are governed.

In the UK, the concept of 'shareholder primacy' underpins our corporate governance model. This doctrine - that shareholder interest has first priority relative to all other corporate stakeholders - is flawed in theory and has economically damaging consequences in practice.

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 - and equity trading has come to be dominated by short-term players, a misalignment of incentives and behaviours has been created between companies, their shareholders and financial intermediaries. Pressures for short-term returns have contributed to 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 per cent to 46 per cent. Only around 25 per cent of finance raised by companies is now spent on investment.

At the same time, the exclusion of employee voice from corporate governance has contributed to Britain's productivity problem. Everyone from the CBI to the Federation of Small Businesses now recognises that employee engagement is a key route to higher productivity. Yet the UK comes sixth from bottom among EU countries (ahead of only Latvia, Bulgaria, Lithuania, Estonia, and Cyprus) in terms of participation and governance rights for employees. There is a strong correlation between countries which have corporate governance systems which include employees, and stronger performance on productivity, research and development and lower inequality.

Runaway executive pay is also related to Britain's system of corporate governance. The UK's executive remuneration process, based on self-referential remuneration committees and pay packages focused on short-term returns, has facilitated rising executive pay unrelated to company performance. For example, over the last 20 years the real value of the FTSE 100 has barely risen, while executive pay has increased by more than 400 per cent. Between 2010 and 2015 alone, the average pay of FTSE 100 company directors increased by 47 per cent, while average employee pay rose by just 7 per cent.

Shareholder primacy is flawed not only in practice but also in theory. In law, companies are not 'owned' by their shareholders. Rather, they are incorporated bodies which bring together a range of stakeholders - owners and suppliers of capital, labour, suppliers and customers - for the purpose of enterprise. There is no reason in law why shareholders alone should have control rights over the company. Shareholder primacy also fails to recognise the critical role played by labour within a firm. Employees are core constituents of the process of production, with long-term and largely exclusive contractual commitments to the company. So they should have a right to representation in terms of the governance of their firm.

This is reinforced by the changing nature of the contemporary capitalist company, where the decline of 'Fordist' models of hierarchical production has placed a premium on human capital in the workplace. Intangible assets 'owned' by employees - their skills, creativity and loyalty - are a key source of value for many companies today, on a par with, or even more important than, physical capital. Yet workers currently do not have governance rights in the same way as owning shares. So there are both ethical and economic arguments for including workers in the way firms are governed.

Reforming corporate governance is therefore critical to addressing the UK's longstanding economic weaknesses. Tackling these problems will require more than tinkering. Instead, a fundamental change in how British companies are governed is needed.

In a report published today for the IPPR Commission on Economic Justice, we have set out three steps to achieving this.

First, company law should be reformed to make long term success, not shareholder returns, the key duty of directors. The law should make clear that the interests of shareholders, while critical, do not necessarily take priority over the interests of employees or responsibilities to other stakeholders.

Second, elected worker directors should be required on large company boards and employee representatives on remuneration committees. This would contribute to the strategic effectiveness of British boards and rebuild the partnership between labour and capital as one of equal standing and voice. One route to achieve this would be through primary legislation, though an alternative option would be reform of the corporate governance code and its application to both listed and private companies.

Finally, a new Companies Commission should be established to oversee and regulate corporate governance and behaviour. Trust between business and the public has been badly eroded by a number of recent scandals, from Sports Direct to NHS. A new, independent Companies Commission could be crucial to rebuilding it, contributing to all our future prosperity.

This is an ambitious agenda to repurpose businesses. Crucially though, there is a Parliamentary majority for bold action. We should seize that chance to create a new partnership between workers, management, and shareholders, building purposive companies that are focused on long-term and equitable success.