The Proof of the Pudding - why the £200 million a year Small Business Research Initiative needs transparent implementation

By David Connell, Senior Research Fellow at CBR, Chairman, Archipelago Technology Group Ltd.

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If you run a small business and need that all important first customer to help you develop and trial your innovative new product, then the Chancellor George Osborne's Budget has some good news for you.

The Small Business Research Initiative which uses government procurement practices to drive through innovation, is to be increased by nearly ten times to around £200 million per annum during this Parliamentary session.

This is excellent news and one that I and others have been campaigning for over the last ten years. But the SBRI will only be successful if it is implemented in a totally transparent and accountable way.

The SBRI is based on a successful and long running US programme called The Small Business Innovation Research Programme. This Programme uses Federal Government procurement expenditure, to give contracts to small businesses so that they can develop technology and products that the US government believes it needs in order to increase the effectiveness of its own departments like Defence and NASA . It also covers projects relating to broader policyobjectives, for instance in the case of the National Institutes for Health. In the US the programme is worth 2.5 billion dollars a year, and it is more important than venture capital in funding the early stages of new science and technology businesses.

In the UK the SBRI is important because it represents a sea-change in the kind of innovation support that the government is giving small businesses. This is because it doesn't focus on "technology push" to exploit our science base, but instead SBRI is much more about stimulating "demand pull". In particular it allows the public sector to play the role of "Lead Customer".

A Lead Customer in the science and technology sector is an organisation that is prepared to fund the development and trialling of new products and technology that then lead onto the purchase of prototypes and their subsequent first use within that organisation. Any organisation that goes first as a customer is taking a risk. For example, if a new UK business sets out to sell a product to a potential customer in the US or Germany virtually the first question they are going to be asked is – "Can you show me one operating in your home market?"

Lead Customers provide product endorsement for further customers and indeed for additional investment if needed. It is commonly thought that the most important source of innovation for science based companies is academic science , withventure capital the primary source of start up funds. But the reality is that for the most successful companies it is nearly always Lead Customers that play both of these roles.

If we look to the US, we know that Microsoft had no venture capital to start with and that Bill Gates was probably unbackable when he started his business! Gates began with a series of paid development contracts for his software and after a time he hit lucky and IBM allowed him, probably by accident, to sell the operating system that he developed for the first IBM PC to other companies. The rest, as they say, is history.

Intel is another example. It was venture capital based at the start, but development of the single chip processor, which has been the key to its success, was actually financed under a contract for a Japanese calculator company. We see this process repeated virtually everywhere. In Cambridge the most successful companies in terms of jobs are based very largely on technology developed for individual Lead Customers and financed by them. So Lead Customers are hugely important if we want to grow our science and technology based sectors.

In 2004 I launched a campaign with the then MP for Cambridge, Anne Campbell, precisely because I became aware as a CEO of a Cambridge Venture Capital Fund of how appalling irrelevant government support for small businesses was in the UK. We achieved success in 2009 when the current UK Small Business Research Initiative was introduced. This operates in a very similar way to the US programme and although it has been up until now quite small scale, about £20 million pounds a year, it has funded some very interesting technology developments in small businesses.

One of the best known SBRI programmes is operated by the NHS. It has, for instance, funded new technology in the area of wound care for individuals suffering from burns or diabetic ulcers. It has also funded a possible cure for macular degeneration which is a major cause of loss of eyesight in older people. A number of these developments look very promising, and some companies have already launched their products onto the market.

Osborne's ten-fold increase in his March 2013 Budget is most welcome but it will however, be quite challenging to achieve that level of growth and there will be some important dangers.

The first danger is that because of the pressure to increase spending government departments will deviate from the model that we know works best. This is precisely what happened in 2005 when Gordon Brown announced a £100 million programme. That programme was implemented through a series of departmental targets with departments reporting expenditure against those targets. The result was that they all reported that they had already achieved their targets without indicating what the figures covered! It will therefore be very important for Osborne's increased programme to be run in a very transparent way. As in the long established US programme, we will need to know what the exact competitions that are being run are and what funding has been provided through those competitions to each company.

But that said, the new £200 million per annum SBRI really is fantastic news for small businesses. It combines both customer demand, allowing businesses to see how potential customers might want to use their new product – and therefore how it should be designed, with funding in a form which is appropriate for them. The traditional mechanism by which government helps small businesses fund R & D is through grants and tax credits and in truth the amounts involved are very small. Unlike these, SBRI contracts provide 100% of project costs and do not require artificial collaborations just to get the money.

It is a myth to think of most new science and technology businesses starting out with bucket loads of venture capital and they are unlikely to achieve the kind of profitability that will enable them to spend significantly on R & D for many years. So what SBRI does for the first time in this Country is give start ups and small companies sufficient funding to make a real difference, increasing their chances of success and accelerating their sales growth. This has to be fantastic news for the UK economy, and for our growth prospects.

Of course, like Oliver Twist, we could always ask for more!

European Court’s Pringle judgment: good law, bad economics

By Professor Simon Deakin

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Courts don't often try to decide the direction of economic policy. However, in effect, this is what the European Court has recently done. In its Pringle judgment the court made a number of important decisions on the legality of bail-out policies being pursued by the European Union.

It ruled that the establishment of the European Stability Mechanism - the fund through which financial assistance will in future be channelled to eurozone states facing the possibility of bankruptcy - was not contrary to EU law. By implication, the ruling also supports the recent attempts by the European Central Bank to shore up the euro by buying the government bonds of debtor states on secondary markets (that is, buying them from commercial banks that have first purchased them from governments).

But the court went further, insisting that the legality of the ESM will in future be dependent on the application of strict conditionality in the terms on which financial assistance is made. In other words, financial assistance under the ESM will only be lawful if it comes with strict conditions, which in practice will amount to instructions to privatise state assets, cut welfare expenditure and abolish labour laws, which currently protect workers against poverty pay and job insecurity. The ECB's bond-buying programmes will be similarly constrained.

In ruling that the ESM is legal, the court gave some much needed flexibility to the EU's emerging economic constitution. The ESM was established in a treaty agreed by the eurozone's members outside the main structure of EU law. Opponents of the stability mechanism argued that only the EU itself had the competence to act in the area of monetary policy. The court sidestepped this argument by drawing a distinction between monetary policy (maintaining price stability) and economic policy (ensuring the wider economic stability of the eurozone). In this way it could conclude that the establishment of the ESM was within the power of the eurozone states. Behind this rather formal legal distinction lay a debate about the steps that could, and should, be taken to save the euro.

The Pringle judgment, in validating the steps taken to preserve the single currency, is a landmark in EU law because it recognises the need for institutional adaptation to deal with an existential crisis that is putting at risk not just the euro, but the wider EU.

But the court's flexibility only went so far. Rather than limiting itself to a judgment on the narrow point of EU law before it, the court ventured into new territory, staking out a claim to channel the future direction of economic policy in the eurozone. This is where conditionality comes in. The court's ruling is intended to give no leeway to the European Commission and ECB in their future dealings with debtor states; financial assistance will not be permitted if it is not linked to structural adjustment packages aimed at cutting welfare expenditure and driving down wages.

At least for the time being, the commission and ECB need no encouragement to go down this path. Yet the results of pursuing this policy with the debtor states since 2010 have been little short of catastrophic. Cuts to social security benefits and wages, and the removal of basic labour protections, have taken demand out of their economies, while doing nothing to address the underlying causes of the crisis.

Under these circumstances, the last thing the EU should be doing is taking additional steps to depress wages and growth. To make this policy the cornerstone of the EU's emerging economic constitution would be a catastrophic error. The policy was misconceived even for the “good times” of the eurozone's early years. But to pursue it to the bitter end in the face of the existential crisis currently facing the union risks undermining all the steps taken to this point to save the single currency. Simply put, without economic growth there is no prospect of confidence returning to financial markets, and the crisis facing the eurozone will continue until the pressures on governments become too much to bear.

To save the euro, and the EU, will require more flexibility in future from its organs and institutions. The court, if it is to play any role at all in this process other than getting out of the way, should recognise the need for a growth-orientated economic policy. If the court were to resist this policy shift in future, it would run the risk of irrelevance at best or, at worst, a loss of legitimacy of the kind that will do the cause of EU law no favours, even if the EU itself survives.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university.

Also posted on FT's Economists' Forum

Rejoining the north European mainstream

By Professor Simon Deakin

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The campaign to increase the £6.19 an hour national minimum wage to a living wage of £8.55 in London and £7.45 in the UK should be supported on the grounds of both equity and efficiency. The living wage is good for families and workers, but also for firms and for the UK economy.

Joint research by the Resolution Foundation and the Institute for Public Policy Research has found that gross earnings would rise by £6.5bn if employees were paid a living wage. It also showed that paying UK workers a living wage would save the Treasury more than £2bn a year by boosting income tax receipts and reducing welfare spending.

This comes as no surprise to those who conduct research on public policy. If employers do not pay a living wage the state has to make up the difference through tax credits. These arrangements benefit no one except, possibly, firms which use tax credits as a pretext for paying low wages. These firms are more profitable as a result and their shareholders may also be better off. But their gains are being made at the direct expense of low-paid workers and the taxpayer.

The Council of Europe sets a decency threshold which implies that the minimum wage should be around two-thirds of the median wage (that is, the wage paid at the midpoint in the earnings distribution). The UK's national minimum wage has generally been around 45 per cent of the median wage since the late 1990s. The gap between the legal minimum and the decency threshold set by the Council of Europe has been met, in practice, by tax credits. This system has been allowed to develop because of fears that a high minimum wage would cause unemployment.

When the minimum wage was introduced in 1998, the Low Pay Commission was set up to advise ministers on its level. The commission was given the remit of determining what the likely economic effects of the minimum wage would be. Its membership consisted of a number of academic economists, in addition to representatives of management and labour. The outcome was a statutory minimum wage set at a level which did not meet families' living costs. To meet the gap, the then Labour government, which was committed to reducing household poverty, expanded the system of tax credits which it had inherited from the preceding Conservative administrations. This worked for a while. The rise in child poverty levels was reversed, but only up to the mid-2000s. The burden on public expenditure of increasing tax credits to make up for persistently low wages was becoming excessive.

The living wage campaign began as a response to adverse effects of low pay on many working households. These included very long working hours which were often spread over two or three separate jobs as earners attempted to meet living costs. Supporters of the living wage do not argue that it should become legally binding in the same way as the national minimum wage. Rather, they call on employers to recognise the principle of the living wage on a voluntary basis, and to make their position known to their contractors and suppliers, and to the public at large. The campaign is based on persuasion and an appeal to employers' enlightened self-interest.

Why would employers want to sign up to the living wage? The direct benefits include a more loyal and highly motivated workforce. Indirectly, employers with a stake in their local community may view the living wage as contributing to social cohesion. This is undoubtedly a factor in the support given to the living wage by many local authorities, hospitals and universities. But private sector employers in the retail and service sectors are also interested. There is a growing realisation that employers cannot insulate themselves from the social consequences of the decisions they make on wages and terms of employment.

What would be the effect of employers more generally accepting the principle of the living wage? Would it increase unemployment? This seems unlikely. One of the arguments for taking a cautious view on the level of the minimum wage in 1998 was that firms had come to rely on low pay as a means of cutting costs. The introduction of a high minimum wage would have been a shock to the economy, leading to increased unemployment. This argument has less resonance today. Employers have had over 15 years to get used to the minimum wage. As a result, the idea that wages should more reflect real living costs is becoming more generally accepted. Because the living wage is not mandatory, progress towards achieving it can be tailored to the circumstances of particular firms.

From the point of view of government expenditure, the living wage would be largely self-financing, thanks to the offsetting effects on tax credits. It would also bring wider benefits to the economy. The most productive economies in the world, those of the Nordic countries and the northern European systems influenced by the German model, either have high legal minimum wages or multi-employer collective agreements which set basic minimum rates of pay which are high by UK standards. These pay norms provide an incentive structure for investment by workers and employers in firm-specific skills. High minimum wages do not work on their own; they must be combined with other policies. These include active labour market policy to support the welfare-to-work transition such as in the Nordic countries, or the national vocational training system in Germany. Such measures might seem expensive, particularly during an economic recession. In fact, they largely pay for themselves once their impact on productivity is taken into account.

The living wage can be the basis for Britain to become a high-wage, high-productivity economy. We should aim to rejoin the north European mainstream on this issue. Looking further overseas, the very last thing we should be doing, if we wish to compete with the BRIC countries, is further deregulating our labour market. Brazil is addressing the issue of informal employment by putting a floor under household incomes through a basic income guarantee, while China has adopted a labour code which acknowledges the need for protection of individual and collective labour rights. These developing economies are gradually building systems of collective wage determination and social insurance of the kind we used to have. They understand that a competitive economy requires labour laws and a welfare state to provide insurance against labour market risks. We have not completely abandoned the same idea, which served us well for most of the 20th century. It is not too late to reconstruct our labour market institutions around the twin themes of equity and efficiency, as exemplified by the idea of the living wage.

Also posted on Progressonline

Shares for Workers' Rights - why entrepreneurial firms need employment law too

By Professor Simon Deakin

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Under the government's current proposals for employment law reform, employees will be able to give up rights concerning unfair dismissal, redundancy pay, flexible working and time off for training in return for receiving shares in the company that employs them, gains on which will be exempt from capital gains tax.

It is right for the government to be encouraging worker ownership in companies; there is abundant evidence suggesting this improves labour productivity. What is completely unnecessary and counterproductive is to link this to the loss of employment protection rights.

Since the early 1970s, under laws initially introduced by a Conservative government, an employee with a minimum period of continuous service (currently two years) is protected against unfair dismissal. This means that if their employer wishes to terminate their employment, they must come up with a good reason, in principle, for doing so, such as misconduct, lack of capability or redundancy. The employer must also show that it has complied with certain procedures, including allowing the employee to put their case in a formal hearing. These laws do not confer a job for life and in no way permit "featherbedding". On the contrary, they give employers ample scope to incentivise and motivate employees. Nor do they prevent firms making workers redundant when there is a downturn in business. Their aim is to ensure that the workplace operates according to certain basic principles of fairness, which most of us could subscribe to: decisions on a matter as important as employment should not be made in an arbitrary fashion.

Although fairness is the main goal of these laws, they also have economic effects. They encourage workers to make a more serious commitment to the firm and to invest their time, effort and loyalty in it. Second, they provide firms with a strong incentive to treat the skills of their workers as a resource to be developed, rather than an asset to be disposed of at will. Employment protection laws encourage a virtuous cycle of investment in the knowledge and processes that are increasingly recognised as essential to economic success, particularly in high-technology sectors.

One of the government's aims in bringing forward this proposal is to encourage the kind of high-tech start ups associated with Silicon Valley in California. Silicon Valley is often said to have a "high velocity" labour market, in which employees move around from one firm to another, thereby promoting the circulation of knowledge. Employers, on the other hand, benefit from the flexibility that goes with having a skilled and mobile workforce. It is often assumed that the right of firms to hire and fire "at will" is critical to this type of flexibility. There is a major problem with this assumption, which is that it is simply not borne out by the facts.

The Californian law on dismissal is actually at the stricter end of the spectrum of US laws on employment. The principle that an employer can dismiss at will – that is, without good cause and on minimal, if any notice – has been qualified by the Californian courts, which require employers to demonstrate that they have acted in good faith when terminating a worker's employment. This principle is not so far removed from the notions of fairness that underpin British unfair dismissal law. The scope of the exceptions to employment at will have waxed and waned over the years, and it is possible to analyse the consequences of this for productivity and innovation. We know from econometric research that there is a correlation between tighter dismissal laws and innovation in California, as measured by increased number of patents and citations to patents. Not just that; as the law imposed constraints on the employer's power to dismiss, the number of small-firm start ups went up, as did the numbers employed in high-tech firms.

British dismissal law, like Californian, has varied over time, creating a similar "natural experiment" for research. The identical effect is also observed: stronger employment laws are correlated with innovation as measured by patents and citations to patents.

The intuition here is clear, and it is backed up by empirical research: when the law limits the right to dismiss, it enhances the confidence of workers that their efforts and knowledge will not be expropriated by the employer. The law can help to create an environment in which firms and workers make mutual investments in new technologies and processes, to the benefit of both sides.

Employment law plays another critical role in supporting technology-based innovation in US firms. In California, so-called "restrictive covenants" that prevent an employee resigning to set up his or her own firm or to work for a competitor are void. Californian courts refuse to enforce such clauses, on the grounds that they are a fetter on competition. This, rather than flexible dismissal laws, is the source of the much-vaunted "high-velocity labour market" of Silicon Valley. How does the UK compare? Under English contract law, contrary to the Californian practice, restrictive covenants are enforced by the courts almost as a matter of routine. We know this matters. When the state of Michigan changed its employment laws to make restrictive covenants enforceable, it saw a decrease in employee mobility.

So if the British government wants to do something to encourage innovation through employment law reform, there are two things it could do. The first would be to strengthen laws that promote fairness in the workplace. The second would be to take a closer look at judicial enforcement of restrictive covenants. There is clear evidence that these contract clauses restrict employee mobility and depress innovation.

Compared with these changes, which empirical evidence suggest would have a tangible effect, the proposed reforms are at best an irrelevance. At worst, they will set back innovation in British high-tech firms.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university

Also posted on FT's Economists' Forum

When US investors took on Japan’s executives

Hedge Fund Activism in Japan: The Limits of Shareholder Primacy, by John Buchanan, Dominic Heesang Chai and Simon Deakin, Cambridge University Press, RRP£60

by Sir Geoffrey Owen

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Whose interests should a company serve? Is it the property of shareholders, for them to do whatever they want with it, or does it have a wider social purpose?

This question lies at the heart of an extraordinary battle waged in Japan in the early 2000s between, on one side, activist hedge funds, mostly coming from the US or the UK, and, on the other, a group of Japanese business executives.

The funds, when they surveyed the Japanese corporate landscape at the start of the decade, saw it as littered with companies that were destroying shareholder value; they were hoarding cash that should have been distributed in dividends and sticking too long with low-return businesses.

The opportunity was obvious, and tempting. Tactics that had worked well in the US and to a lesser extent in the UK - identifying likely targets, acquiring a sizeable equity stake and then putting pressure on the directors to disgorge surplus cash - seemed certain to generate higher share prices. The hedge funds saw themselves as the shock troops of shareholder primacy.

Managers of the targeted companies, for their part, had little interest in shareholder value; they barely understood what the words meant. What mattered to them, and what constituted "corporate value" in their view, was not the share price or any other financial measure, but the ability of the company to prosper and to grow over the long term.

Like most Japanese executives, they saw the company as a community, a concept which, as Buchanan, Chai and Deakin explain in this well-researched and illuminating book, took root in Japan in the reconstruction years after 1945. Under this approach the interests of the company, and by extension those of the employees and customers who sustained it, were given priority over those of investors.

Not surprisingly, the invasion of the hedge funds led to confusion and acrimony. When Steel Partners from the US bought shares in Bull-Dog Sauce, a food manufacturer, and later announced its intention to take over the whole company, the Japanese managers were bewildered. Why had a 100-year-old company with a respectable record suddenly been put in play? What did Steel Partners know about the food industry? When the heads of the warring parties met face-to-face, the discussion merely reinforced the Japanese view that Steel Partners was not out to improve Bull-Dog but was simply a predator.

Bull-Dog adopted a defence strategy the Americans claimed was illegal but the Tokyo High Court ruled that the hedge fund was "an abusive acquirer" and that the defensive measures were legitimate. Although the Americans made a useful profit when they sold their shares, the outcome - like that of another contest, involving British hedge fund The Children's Investment Fund - showed that aggressive tactics by activist investors were unlikely to succeed in Japan.

In other ways - and for this the hedge funds can claim some credit - the Japanese system did become more shareholder-friendly during this period. Foreign institutions were increasing their holdings in Japanese companies; while they did not seek confrontation, they expected dialogue with the directors and higher standards of corporate governance, including in some cases the appointment of independent directors.

The head of Steel Partners once said he wanted to "enlighten" Japan about shareholder value. Today, shareholder value is a valid topic for discussion, but in no way the driving force behind management decisions.

The survival of the company as an enduring organisation still remains a more important consideration in Japan than the investors who happen to hold the shares at any given time.

The writer is author of 'The Rise and Fall of Great Companies: Courtaulds and the Reshaping of the Man-made Fibres Industry' and a former editor of the Financial Times

Also posted on FT's Business Books

Don’t shoot the pension fund managers!

By Professor Simon Deakin, Director, Corporate Governance Research Programme, ESRC funded Centre for Business Research, University of Cambridge.

Long-term investment in infrastructure needs a better policy mix

George Osborne's attempts to encourage British pension funds to invest more in infrastructure projects are to be applauded. Canadian and Australian pension funds have already invested heavily in infrastructure, but UK funds are still reluctant investors. Why?

British prime minister David Cameron tours Newton Heath rail depot. Getty images

Pension fund trustees have a fiduciary duty to get the best return for scheme members after taking due account of risk. Government cannot and should not dictate how or where and how these funds invest their assets. If government wants pension funds to engage with the long term needs of the UK economy, it must first understand the particular pressures they face as investors.

Pension funds must invest for the very long term because their beneficiaries, the scheme members, will be receiving their pensions decades after making their contributions. As investors, however, the pension schemes cannot just take the long view. They must balance risks and returns over the investment cycle, which in practice means taking advantage of liquidity when it is available and making the most of opportunities for profit taking when they arise. Thus it is implausible to believe that the interests of pension funds are automatically aligned with the public interest in sustainable infrastructure. The right incentives and structures need to be put in place to support infrastructure investment.

What can be done? We need to address both sides of the issue. On the one hand, an acceptable division of investment risk between pension funds and the government must be found. On the other, the risks associated with the organisation of large-scale infrastructure projects - so-called construction risk - need to be better understood and managed.

Let's take investment risk first. There is demand, on the part of pension schemes, for long-term investments which will provide a stable return. An asset class based on infrastructure investment may well provide part of the answer. Government would need to play a role in inflation-proofing and underwriting part of the financial risks. From the government's point of view, infrastructure bonds which operate in a manner similar to inflation-proofed gilts could be a feasible option, but not if they result in private investors just shifting long-run costs on to the public finances in the manner of PFI (‘moral hazard'). Getting this right, and avoiding the pitfalls of PFI, will require a high degree of transparency and trust on both sides in coming months if a viable solution is to be found.

M4 motorway near Bristol. Getty images

Now let's consider construction risk. Pension funds argue that too many large construction projects don't deliver, pointing to cost overruns and delays in completion on projects like Wembley stadium and the Jubilee Line extension. For this reason, they are more enthusiastic about investing in so-called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management.

From the pension funds' point of view, the government could solve the problem of construction risk for them by simply underwriting potential losses. The difficulty with this is not just that the Treasury has limited capacity to take such an open-ended risk, but that to do so on an open ended basis would risk repeating the ‘moral hazard' problem associated with PFI.

At least part of the solution must lie in addressing construction risk at its source, in the way projects are managed. Enormous strides have been made in recent years in managing the risks of large infrastructure projects, with the construction of the Heathrow Terminal 5 building leading the way. Lessons from Terminal 5 and other successful projects have been embedded in the procurement process and contractual design of the construction of the 2012 Olympics site. The construction industry has been actively promoting good practice through modifications to the standard-form contracts used in infrastructure projects. The government has encouraged this process and needs to continue doing so.

A British Airways aircraft takes off from Terminal 5. Getty images

Getting infrastructure investment right is therefore a twin-track process. The role of government is not to impose solutions on finance or industry, but to identify good practice and encourage information exchange and dialogue between the two sides. If the government sees its role in these terms there is every prospect of a workable set of solutions emerging.

The issue of infrastructure investment has wider lessons for economic governance in the UK. The question George Osborne needs to ask is: what can be done to encourage an investment regime that more effectively internalises the risks of complex projects, not just in infrastructure but more generally in innovative areas of manufacturing?

On the finance side, this means thinking about the way that pension funds are structured and governed, and about the role played by asset management firms and other market intermediaries in the investment process. Are the right structures and incentives in place for pension funds and their agents to represent the interests of scheme beneficiaries in stable returns which also bring wider benefits to the UK economy?

On the corporate side, some thought needs to be given to whether company law and associated regulatory measures, such as the Takeover Code, are sending boards of listed companies the right signals.  A legal and regulatory regime which is widely, if arguably incorrectly, interpreted as requiring listed companies to prioritise short-term shareholder value, is not compatible with the country's long-term investment needs. Are Britain's corporate governance arrangements, so long held up as an example to the world, part of the reason for the continuing decline in investment in R&D by UK firms, by comparison to our competitors, and for the presence of no more than a handful of globally successful British manufacturing companies when Germany and Japan have a dozen or more each?

Also posted on FT's Economists' Forum

Kay needs to replace “shareholder value” with “corporate value”

By Professor Simon Deakin, director, Corporate Governance Research Programme, Centre for Business Research, University of Cambridge

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John Kay's interim report finds that equity markets are failing in their primary tasks, which he identifies as enhancing the long-term growth of listed companies and providing savers with an appropriately high, risk-adjusted return on their investments. The failure lies, he suggests, in the way that market actors are currently incentivised. If asset managers are assessed on a quarterly or biannual basis, it is not surprising that they apply benchmarks based on the short-run performance of the firms they invest in.

Corporate managers, on the other hand, believe that they have a legal duty to maximise short-term shareholder value, and act accordingly. Kay rightly suggests that this view is mistaken as a matter of law but, again, it is no surprise that directors and managers think in these terms, given the way that shareholders are routinely described as the 'owners' of the firms they invest in. Disclosure rules add to the problem, in particular those requiring quarterly reporting of corporate results. Lawyers will recognise that shareholders are the owners of their shares, not the company, and that they have no right to manage the firm, having delegated this power to the board, but these subtleties are clearly being lost in translation.

What can be done?

It is not just a question of getting across a more accurate understanding of the legal structure of the company limited by share capital. The idea that managers should run listed companies in such a way as to maximise share prices is deeply embedded in UK corporate governance practice. It is reflected in the way top managers are remunerated, through bonuses and options linked to share price movements, and in the way that company performance is benchmarked, through metrics such as earnings per share and return on equity. Kay takes aim at some of these practices which, he points out, do not just privilege the short-term, but also tend to discourage large-scale capital investment by companies.

Kay also reports suggestions that there are elements in the regulatory framework beyond company law which favour corporate restructuring and deal-making over long-term growth, notably the City Code on Takeovers and Mergers. While the Takeover Panel's view that the principal aim of the Code is to protect minority shareholders is undoubtedly correct, it is no less clearly the case that its main effect is to facilitate hostile takeovers of UK-listed companies by denying boards the room for manoeuvre that they would have in virtually every other developed economy.

How should these concerns be addressed?

The final report will have to set out a plausible agenda for regulatory reform if it is to be more than a well intentioned review of existing practices. There are some practical changes Kay could suggest such as making clarifying the legal duty of the board to have regard to the long-term interests of the company under section 172 of the Companies Act 2006 and making clear that this duty takes priority over the terms of the Takeover Code. But going forward, Kay also needs to give a clearer account of the philosophy that would guide reform.

Kay argues that shareholders should act as 'stewards' of the companies they invest in. This is fine as far as it goes, and may chime with the ambitions of some pension fund trustees and asset managers to support investment in innovative manufacturing and infrastructure. However, the final report needs to recognise that there are numerous instances in which the interests of shareholders simply do not coincide with the wider public interest in maintaining a sustainable and competitive corporate sector in the UK.

The restructuring of British enterprise through hostile takeover bids, hedge fund activism and private equity over the past three decades was not just the consequence of decisions taken by capital market intermediaries acting without regard to the interests of their shareholder 'principals'. Institutional investors were highly critical of listed companies which did not prioritise shareholder value, and pressed for a greater role for independent directors on boards as a way of getting their views across. There is more than anecdotal evidence that some of the deals involving the restructuring of companies with a core role in the British economy, from the takeover of BAA by Ferrovial through to RBS's bid for ABN Amro, were driven by a combination of pressure from boards and shareholders for quick returns, with considerations of corporate strategy pushed to the margins.

It is naive to see hostile takeovers, private equity and hedge fund activism as addressing problems of 'failed' companies. Much more often, these forms of investment simply extract value from companies for the benefit of investors and intermediaries, at a direct cost to workers (who lose jobs and protected terms and conditions of employment), customers (who experience a deterioration in the quality of products and services) and the taxpayer (who foot the bill through tax reliefs on corporate leverage).

What has brought us to this point?

Since the early 1980s, company law and corporate governance regulation have given shareholders many more rights to 'hold management to account'. Kay recognises that trading in the secondary market for shares does not bring in new capital for firms, but he justifies shareholder influence on the grounds that investors can exercise effective oversight over firms' capital allocation decisions and over their governance. This is implausible.

In today's liquid capital markets, shareholders are for the most part transitory owners who have no lasting connection to the firms whose traded securities they hold. The question we should be asking is why law and regulation have ceded such large influence to this group. It is partly intellectual fashion, a misguided belief in the informational efficiency of liquid capital markets. It is also down to intense lobbying by the market intermediaries (the asset management firms, legal advisers and investment banks) who benefit most from current arrangements.

John Kay is on the right path in arguing for a long-term approach to investment decisions, but too optimistic in believing that shareholders will always act as enlightened owners.

We need to replace shareholder value with corporate value as the objective of management and take a detailed look at corporate governance regulation and practice with this guiding principle in mind. If this means sidelining the Takeover Code and subordinating it to the wider goal of a reformed company law in promoting sustainable enterprise, so be it. This is the kind of hard choice we will have to make if we want capital markets to make a real contribution to prosperity and growth.

Also posted on FT's Economists' Forum