This, coming from the chief executives of 181 of America’s largest companies, caused quite a stir. It seemed to rebuff a treatise by Milton Friedman, dating back 50 years, on which the shareholder-is-king doctrine was based. UK businesses could be forgiven for greeting it with a wry smile, for stakeholder priority has been baked into UK law since 2006, when the UK Companies Act became the longest piece of legislation ever passed by the UK parliament.
Section 172 of this Act says that directors have a duty to make their company successful – and sets out what they must do to achieve this. It places a legal duty on directors to “have regard to the likely consequences of any decision in the long term” and to take into account “the interests of… employees” and “relationships with customers, suppliers and others”. It also demands “high standards of business conduct” and requires the board to be concerned about “the impact of the company’s operations on the community and the environment”. In other words, focus on your stakeholders and profits will follow. The message is that directors can be held to account if they obsess about profits at the expense of everything else.
Exploitation fails
That’s all very well in theory, but does it work in practice? The inappropriate drive for profits had certainly failed Tesco (TSCO), as Dave Lewis found soon after he replaced Phil Clarke as its chief executive in 2014. His previous company, Unilever (ULVR), had been on the receiving end of Tesco’s squeeze on its suppliers – so it can’t have been a surprise to learn that Tesco’s executives had been under extreme pressure to deliver over-demanding financial targets. To achieve their targets, they’d resorted to delaying payments, but they’d also had the wheeze of bullying suppliers into becoming a revenue stream. They’d been demanding upfront fees to sponsor promotions. That distorted the selection of products offered to customers. Factor in other inappropriate cost-cutting measures and it was hardly surprising that Tesco was losing market share to competitors such as Aldi and Lidl.
Worse, Tesco had been boosting its apparent profits by pulling forward income from subsequent reporting periods. That meant that investors were basing their decisions on misinformation, which risked creating a false market in its shares. One of Mr Lewis’s earliest challenges was to establish what was going on, sack those responsible, come clean publicly and issue a profit warning.
Its directors had collectively contravened their legal duty to employees, suppliers and customers. Some later resigned. Executive heads rolled and three former employees were subsequently prosecuted for fraud and false accounting. They were acquitted in 2017. Tesco became subject to a deferred prosecution agreement and the Serious Fraud Office fined it £132m.
The textbook turnaround
Not the best of beginnings for a new chief executive? Some say it was ideal, because such scandals break down internal resistance to change. According to the 19th annual CEO Success study by PwC’s Strategy&, chief executives need to master five ingredients. The first two are: to set his/her own style (brand) and to (re)set the agenda. Mr Clarke had been groomed internally for the role, and had juggled with the strategy bequeathed by Sir Terry Leahy, who’d quit while the going was good in 2011. That strategy had become regarded as a poisoned chalice. For Mr Lewis to restructure its operations now would be like pushing at an open door.
PwC also says that it’s important to engage the board as a strategic partner – don’t just get them onside but tap into their insights and experience to help shape policies. And find the right pace for change. This means a balance between moving forward fast enough to deliver the new critical priorities, while avoiding rushing through quick gains that could prove counter-productive. And the last vital ingredient: get your people behind you and harness the company culture. Sure, executives can lay down guidelines for employees, but getting things done depends on all those informal, emotional relationships that make the organisation tick.
Mr Clarke had managed to sell Fresh & Easy, Mr Leahy’s disastrous expansion into the US. It had lost over a billion pounds, and a couple of years after Tesco got shot of it, it filed for bankruptcy. Mr Lewis set about streamlining operations by selling off more non-core ventures, including Blinkbox, the Hudl tablet, Harris + Hoole coffee shops and operations in South Korea. He cut costs by expanding its own-brand products, which are cheaper for both Tesco and its customers, and he rationalised property costs. In 2017, he risked acquiring wholesaler Booker, which expanded Tesco’s presence in convenience retail and catering, and which, like the strategic alliance with Carrefour, brought greater economies of scale. And Section 172 of the Companies Act? His overarching achievement over the past five years has been to restore the trust and loyalty of both customers and suppliers. He’s ticked all the boxes and Tesco’s share price has gone up by about a third since he joined.
He had customers and the environment in mind when, at the half-year results analyst conference, he stressed how his executive team were reducing packaging and the use of plastic. Cutting food waste and minimising food miles are also high on the agenda. This involves working with suppliers, and Tesco has the greatest leverage over its own-brand products. At the time of the 2019 annual report, he said that 2,900 tonnes of hard-to-recycle material had been removed from it’s own-brand products. And made a shock announcement. He had decided to step down. Why? Because Tesco never sleeps – and “the operational intensity” over the past five years has been remorseless. He needs to “recharge his batteries”.
What chief executive moves can tell us
Mr Lewis’s is just one of many recent chief executive departures. PwC says that of the world’s largest 2,500 companies, the proportion of chief executives leaving their posts last year was 17.5 per cent. That’s the highest rate this century. And since then it seems to have accelerated in the UK. Could that be because the challenges have become more demanding and bosses foresee greater headwinds to come?
Most departures are planned, but the report notes that globally, a third of chief executives who leave within five years were… fired. And it warns about the best-laid succession plans: “Long-serving chief executives typically play a key role in arranging a smooth succession to a carefully chosen insider executive at their company,” it says. “Although they often have much in common with their predecessors in terms of their backgrounds, successors turn in significantly worse financial performance, generally have shorter tenures, and are much more likely to be forced out rather than to depart via a planned succession.” That’s because directors and investors are less inclined to challenge long-serving (generally successful) chief executives. As Tesco demonstrated after 2011, the problems become evident only after the hand-picked successors take over. In fact, “the longer the long-serving chief executive’s tenure, the worse the successor performed”. There’s a message here for investors: be wary of such situations.
Faultlines
What prevents companies from focusing more on stakeholders? The short answer is it risks losing the chief executive his or her job. The time taken to win stakeholder loyalty can be an issue. Mr Clarke arrived with high expectations in 2011 and expanded Tesco into coffee shops and restaurants to attract more custom to its stores. Given time, this might have paid off, but in the meantime, its share price was falling. How are outsiders to know whether setbacks are temporary? They could be due to more enduring problems. Fund managers, under pressure to outperform their benchmarks, tend to play for safety and lobby for change.
Stakeholder focus can also shave margins. Unilever’s policy of environmental sustainability (and the scrapping of its short-term sales targets) was perceived to constrain its profits. The prospect of reversing the policy to unlock shareholder value probably helped to attract Kraft Heinz (US:KHC), which made its opportunistic bid in 2017. That was fended off, but soon afterwards the board began searching for a replacement for Paul Polman, Unilever’s chief executive.
Further tightening
The direct sanction of Section 172 of the Companies Act is resignation. Thick-skinned directors might not, but shareholders can in theory vote them out. Indirectly, the pressure comes from legislation against the company. If a supermarket committed a similar offence to Tesco today, for example, the Groceries Code Adjudicator has the power to fine it up to 1 per cent of its annual revenues.
Other pressure comes from more explicit reporting. From 2020 onwards, annual reports of larger companies will have to say how stakeholder interests have influenced their main decisions. They’ll have to include the ratio of how much chief executives have received compared with the pay of their employees – and to account for changes from year to year. And because of concerns about rewarding success too much, they’ll have to illustrate the effect of share price appreciation on the cash and shares awarded as part of pay.
Like the UK, the US can levy fines for transgressions, but its controls on directors continue to lag behind. For example, it’s not uncommon for the role of chief executive and chairman to be combined in North America, a practice that’s been frowned upon here for some time. And remember that 1970 Milton Friedman treatise that put the shareholder first, and which the UK diluted years ago? It mentioned stakeholders by saying that employers could strengthen their businesses by devoting “resources to providing amenities to their local community” and “to improving its government”. But the key aspect that the US Business Round Table had overlooked was a line saying that company bosses should focus on the longer term, even if today’s investments will take some time to become profitable.
Today’s investments are clearly not the only thing to take a long time to percolate through.
