Tuesday, November 03, 2009

Controlling Corporations: Stockholders vs Stakeholders

In theory, private corporations are run for the benefit of their stockholders. Insofar as the theory is enforced in practice, it is through two different mechanisms. One is the fiduciary obligation of corporate directors, the fact that they are legally obliged to run the firm in the interest of its stockholders. How much effect that obligation has is not clear, given the obvious difficulties with having a court second guess the decisions of the firm. The second and more important mechanism is the fact that the board of directors, which has the power to hire and fire management, is itself elected by a vote of the stockholders. If holders of a majority of the shares are unhappy with how the corporation is being run, they can replace the existing board, and so the existing management, with people who will run it more nearly as they wish.

This mechanism, like democratic voting in the political arena, faces an obvious problem; the holder of a share of stock, like an individual voter, knows that his vote is very unlikely to change the outcome and so has little incentive to spend time and energy judging how well the firm is being run in order to exercise his voting power. But votes in the corporate context, unlike votes in the political context, are transferable; each is attached to a share of stock, and shares can be bought and sold. If a corporation is doing a sufficiently bad job of maximizing stockholder value, someone with the necessary assets and expertise can buy up lots of shares at a price reflecting the current performance of the corporation. Since owning lots of shares gives you lots of votes, he can then, perhaps in alliance with other large shareholders, vote out the board, replace management and, when it becomes clear to others that the firm is now doing better for its stockholders, sell his shares at a higher price and go looking for another badly run firm to buy stock in. Takeover bids generally get a bad press, possibly due to the efforts of incumbent managers who would prefer not to be replaced, but they provide people running corporations with an incentive not to deviate too far from doing what, in theory, they are supposed to do.

Some people—including a colleague of mine whose recent work inspired this essay—argue that the theory itself is wrong. Decisions made by a corporation affect not only the stockholders but other people as well, most obviously its customers and employees. Why not alter the legal rules in ways designed to give all "stakeholders," all people affected by the corporation's decisions, a voice—either by altering the legal rules to broaden the fiduciary obligation of directors or by changing the rules on how directors are chosen to give (at least) customers and employees some votes as well?

There are a number of problems with the argument; in this post I will focus on one of them.

Corporations are constrained in at least three different ways. Two of them are the legal obligations of the directors and the mechanisms for electing them. The third constraint is the market on which a corporation sells its outputs and buys its inputs. A customer who finds that the corporation is not serving his interests, that its products are more expensive or less desirable than those offered by competitors, does not have to intervene in the internal affairs of the corporation in order to solve the problem. He can simply stop buying what the corporation is selling. An employee who finds that the corporation is offering less money for a less attractive job than alternative employers can quit. Since the corporation requires customers to provide the money with which it pays dividends to its stockholders and salaries and bonuses to its management, and requires employees to produce the goods and services that it sells to those customers, it has a direct and immediate incentive to produce what customers want to buy and provide employment terms that employees are willing to accept.

Like most mechanisms, this one is imperfect. Customers are not perfectly informed about what they are getting or the alternatives, and some customers for some goods and services are to some degree locked in by previous choices. Having spent time and effort learning to use the hardware and software on which I am writing this, I would be willing to switch only if the quality went down quite a lot or the price up quite a lot, so the firms providing the hardware and software have some ability to benefit themselves at my expense without losing my business. Having accepted my current job, there would be significant costs to shifting to another—costs of learning my way around a different university, perhaps of moving to a different location. Hence my employer as well has some ability to benefit itself at my expense.

But my situation as customer and employee is very much better in this respect than my situation as a stockholder. It is true that, as a stockholder, I have the option of selling my shares of stock, which at first glance looks rather like my option as a consumer of not buying a product or as a worker of quitting a job. But the apparent similarity is an illusion.

If I choose not to spend twenty thousand dollars buying a car from Ford, Ford has one more unsold car and twenty thousand dollars less money. If I choose to sell twenty thousand dollars of Ford stock, on the other hand, the money I get is not coming at Ford's expense. Another investor has paid me the money and now owns the stock, leaving Ford itself unaffected. From the standpoint of the firm's incentives, it is as if, every time a customer wished to stop buying from a store, he was required to first find a new customer willing to take his place, or as if an employee could only quit if he provided a replacement willing to do the same job at the same pay.

The stockholder's view of the value of the stock directly affects the firm only if the firm wishes to raise capital by selling a new issue of stock. So far as existing stock is concerned, the shareholder is locked in, even if the fact is not immediately obvious. If the firm is being run in a way that fails to maximize stockholder value, he cannot escape that cost by selling his share, since the price he can sell it for will reflect the reduction in future profits and dividends, insofar as it can be estimated by other stockholders.

It follows that stockholders, unlike customers and employees, receive no direct protection from the market on which they deal with the firm. As a customer of Apple, I am to some limited degree locked in; I can switch to hardware and software from another firm, but only at a significant cost. The same is true of my situation as an employee of Santa Clara University. In both cases, I have born what are now sunk costs as a result of my initial decision to buy a product or accept a job. But as a stockholder in Apple, I am entirely locked in; all of my cost is sunk. If Steve Jobs announces tomorrow that he plans to run Apple entirely for the benefit of its employees and customers, never paying another dividend, the fact that I can respond by selling my stock provides me no protection.

It follows that the stockholder is dependent, very much more than the other stakeholders, on other mechanisms for controlling a firm to make it act in his interest. That is a strong argument in favor of the current mechanism for corporate control and the current legal rules defining the fiduciary obligation of the directors.

Indeed, it is an argument for more than that. It is an argument for strengthening stockholder control in order to provide more protection to the most vulnerable party in the network of relationships that makes up a corporation. One way of doing so would be by removing current legal barriers that make takeover bids more difficult, and so protect managers and directors from the consequences of serving their own interests at the expense of the stockholders whose interests they are supposed to be serving.

25 Comments:

At 10:13 AM, November 03, 2009, Blogger Michael F. Martin said...

Takeover bids generally get a bad press,

Especially after the bond market freed up in the 1980s, it became very cheap to borrow cash to buy shares. That meant that managers' time horizons had to shorten because LBO funds could come in and break up the company for its asset value if they didn't consistent post higher profits, and hence get higher P/E multiples. The bad reputation is earned despite the salutary effect that takeover threat might have on some managers. The easy availability of leverage here is something Austrians would tsk, tsk at, while Chicago school folks would merely shrug. Worth noting.

A customer who finds that the corporation is not serving his interests, that its products are more expensive or less desirable than those offered by competitors, does not have to intervene in the internal affairs of the corporation in order to solve the problem. He can simply stop buying what the corporation is selling. An employee who finds that the corporation is offering less money for a less attractive job than alternative employers can quit. Since the corporation requires customers to provide the money with which it pays dividends to its stockholders and salaries and bonuses to its management, and requires employees to produce the goods and services that it sells to those customers, it has a direct and immediate incentive to produce what customers want to buy and provide employment terms that employees are willing to accept.

This is an EMH-type argument. It assumes that customers and employees preferences are fixed, and that the firm or market is mereley discovering these preferences through allocation and reallocation over time. If preferences are mutable, and especially if the firm can influence how those preferences evolve, then this argument is fatally flawed.

Are preferences fixed? By some approximation, yes. But it's where that approximation fails that there is lots of action right now.

Consider how economics might look if we merely optimized the flow of input and output from various groups within the economy, remaining agnostic as to how the input and output might be modeled in utility functions. Frequency and phase-matching input to output requires optimization over some spatial and temporal horizon.

Is there a principled reason why that optimization should be constrained to maximize benefits for shareholders? Perhaps when capital was the most important constraint on production. That is no longer the case in many places.

 
At 10:55 AM, November 03, 2009, Anonymous BlackSheep said...

An interesting question is why don't we see alternative systems emerging if indeed better alternatives exist. Why don't we see alternative stock markets where take-over bids are facilitated? Why don't we see alternative organizations where customers and employees share seats in the board room? If indeed changes to those schemes produce a positive net value, transactions ought to exist to get to that point, so what's precluding them?

 
At 11:02 AM, November 03, 2009, Anonymous BlackSheep said...

Michael, if the company is priced over its net present value, why should it not be stripped of its assets?
Please expand that part of your post because it seems interesting.

 
At 11:03 AM, November 03, 2009, Blogger Michael F. Martin said...

BlackSheep,

The short answer is that government regulations impose large transactions costs that are not easily borne by dispersed stakeholders. The longer answer is that we do:

http://venturebeat.com/2009/06/11/trying-to-sell-shares-in-a-private-startup-join-the-club/

 
At 11:09 AM, November 03, 2009, Blogger Michael F. Martin said...

BlackSheep,

I think you mean if the company's net present value in profit is less than its asset value, then why shouldn't it be liquidated.

The answer is that sometimes the profits are low because the managers are idiots. Look for studies on how companies run by their founders tend to outperform.

 
At 2:02 PM, November 03, 2009, Blogger Jonathan said...

Interesting, well expressed, and highly comprehensible even to non-economists like me. Thank you.

 
At 2:11 PM, November 03, 2009, Blogger David Friedman said...

"Why don't we see alternative organizations where customers and employees share seats in the board room? "

We do. I'm a member of two consumer coops, one a bookstore and one a supermarket, both in the Hyde Park area of Chicago. I haven't lived there for fifteen years or so, and when I did made no attempt to use my membership to influence the organization--which suggests one reason why that form of organization doesn't have any significant advantage.

Law firms are typically structured as workers' coops, although only a small fraction of the workers are included.

All of which I was planning for my next post on the topic.

 
At 3:52 PM, November 03, 2009, Anonymous Anonymous said...

As to alternative forms of organizations and their relative advantages, you might be interested in Henry Hansmann's The Ownership of Enterprise.

 
At 5:26 PM, November 03, 2009, OpenID hudebnik said...

Corporations are constrained in at least three different ways. Two of them are the legal obligations of the directors and the mechanisms for electing them. The third constraint is the market on which a corporation sells its outputs and buys its inputs. A customer ... can simply stop buying what the corporation is selling. An employee ... can quit.

Another group of stakeholders in a corporation's behavior is "the public", even those who neither work for nor buy from the corporation. How can one effectively constrain a corporation from doing things that benefit its managers, stockholders, employees, and perhaps even customers, but externalize their costs to everyone in the world?

 
At 5:31 PM, November 03, 2009, OpenID hudebnik said...

Michael makes an interesting point: easy takeovers tend to encourage corporations to discount the future heavily -- to make decisions in favor of short-term over long-term profitability. There's probably a market-based solution to this: some kind of "long-term shares"?

 
At 5:36 PM, November 03, 2009, Blogger Michael F. Martin said...

The market-based solution is slow capital, which tends to produce better-than-market returns. Berkshire-Hathaway is a good example. Read Buffett's letters to his shareholders. Most of them are partly advertisements to family-owned businesses to trust him not to break up the company.

 
At 8:48 PM, November 03, 2009, Blogger David Friedman said...

Easy takeover only leads to heavily discounting the future if the future isn't sufficiently predictable to be capitalized into the value of the stock.

And, of course, the less predictable the future is, the less sense it makes to bear short term costs in exchange for (what you hope will be) long term benefits.

 
At 7:57 PM, November 04, 2009, OpenID hudebnik said...

Easy takeover only leads to heavily discounting the future if the future isn't sufficiently predictable to be capitalized into the value of the stock.

I'm not sure that's true, for two reasons. First, many "takeover specialists" have no interest in running a company for very long; they want to take it over, shuffle some assets around so it looks better to potential buyers, and sell it for a profit as quickly as possible. In other words, they heavily discount the future, even if some other investor might not, because they have different personal priorities.

Second, the "takeover specialist" by definition is changing the company's future from whatever somebody might have predicted before the takeover. Discounting the future can become a self-fulfilling prophecy (like short-selling), if the takeover specialist sells off things the company would have needed for its long-term health.

 
At 10:20 PM, November 04, 2009, Anonymous David Yosifon said...

Thanks for your insightful and challenging post, David. But riddle me this -- given the market for control, why should I as a shareholder be worried about having to find a buyer before I can exit? As soon as it becomes profitable, a buyer emerges, and I can get out. So my stock won't fall much below what I paid for it, not as a consequence of slacking anyway. On the other hand, once I'm addicted to some consumption, or have sunk costs as you describe, I'm stuck.

 
At 12:28 AM, November 05, 2009, Blogger David Friedman said...

"given the market for control, why should I as a shareholder be worried about having to find a buyer before I can exit? As soon as it becomes profitable, a buyer emerges, and I can get out. So my stock won't fall much below what I paid for it, not as a consequence of slacking anyway."

A buyer emerges--but at what price? If slacking by management means that the company isn't maximizing its profit and isn't going to, and other buyers can see that as well as you can, you will be able to sell the stock only at a price that has already capitalized the loss.

 
At 8:15 AM, November 05, 2009, Anonymous David Yosifon said...

David, you wrote: "A buyer emerges--but at what price? If slacking by management means that the company isn't maximizing its profit and isn't going to, and other buyers can see that as well as you can, you will be able to sell the stock only at a price that has already capitalized the loss."

But doesn't that mean that the threat of slacking, or slacking itself, was already impounded into the price that I paid for the stock? Also, pace Henry Manne, the very threat of the market for control restrains managerial slacking.

 
At 4:08 PM, November 05, 2009, Anonymous Anonymous said...

"...the fact that they are legally obliged to run the firm in the interest of its stockholders."

Consider the case where firm A profits at the expense of firm B. Shareholders in general own both firms, so there is no shareholder benefit. In theory, there might not even be a single shareholder who benefits, since it's possible for all shareholders to be diversified (though in practice some aren't).

 
At 9:49 AM, November 06, 2009, Blogger neil craig said...

I'm from Britain so I don't really know but would have thought that a Republican stronghold in New York would have been le4ss Republican than most parts of the country. So if the "leftist" Republicans, by going over to the Democrats, can only just throw the seat to them then in other areas they are going to prove a very small part of the Republican vote. There is also the fact that the timing of betrayal is vital (as indeed in Heinlein's book where the ultimate sign of nastiness is quitting a campaign in the middle, albeit not by its leader) & that if this does have repercussions discrediting some Republican leaders it will all be done & dusted before the next Congressional elections.

 
At 9:56 AM, November 06, 2009, Blogger neil craig said...

Sorry - obviously I put the last comment on the wrong thread. Feel free to delete.

 
At 8:13 AM, November 09, 2009, Blogger John Fast said...

If I understand him correctly, Michael F. Martin is concerned that a company might be taken over and broken up and the various assets sold off.

This could happen (again if I understand him correctly) if the short-term value of the company as a whole was less than that of the assets, either because the managers were idiots, or because they were doing some things which caused temporary short-run problems but were going to more than compensate it in the long run.

I agree with him that liquidating a company in such a situation would be bad because it would be more productive in the long run to keep the company intact. This is obvious and well known, and followed in practice (at least when it's not prevented by law).

If the directors are idiots, an LBO or other hostile takeover will be organized to take over the company and fire the idiots, to replace them with competent directors who will change the company's policies but still keep the company together, because that would be more profitable than liquidating it.

Even if there were a takeover bid made by some other idiot who wanted to liquidate the firm, he would be outbid by the non-idiots who see how to run it properly, i.e. to produce more social benefit ("profit") from operating it than from liquidating it.

If the current directors are *not* idiots, i.e. they are simply taking steps which cause a drop in short-term profits but will pay off handsomely in the long run, then the issue is merely short-term versus long-term gain. In other words (if I understand him correctly) Mr Martin is concerned that the stockholders are myopic; that they're not willing to accept short-term sacrifices even though it will be more than worth it.

I'm skeptical of that, at least if it's clear (and reasonably certain) that the long-term benefits will be worth it. (After all, stockholders are smarter than voters, or rather people are smarter with their stocks than they are with their votes.) But if they are willing to give up their share of the long-term profits then let them; there will be an LBO -- possibly by the very executives who are running the company and who presumably believe in their plans -- to keep the company together for the long haul.

 
At 9:03 AM, November 09, 2009, Blogger Michael F. Martin said...

John Fast,

You've got it. All I will add is that the specific idiocy I had in mind was of some managers serving the myopic shareholders by catering to analysts, e.g., who look for consistent quarterly gains at the expense of investment in long-term growth, which always requires a short-term hit.

Some people would say these managers are not idiots; they are merely playing the game that analysts, instituional investors, and GAAP have set up. I see that. That's why accountig reform is the single most important effort to prevent another crisis. We can't leave accounting to accountants.

 
At 9:13 AM, November 09, 2009, Blogger Michael F. Martin said...

Oh, and as to the question of which group is more myopic -- existing shareholders or LBO managers -- remember what the L in LBO stands for -- other peoples' money.

 
At 1:22 PM, November 10, 2009, Blogger Scott said...

David,

Have you ever read Roderick Long's Stakeholder Theory for Libertarians? You can find it here: praxeology.net/stakeF04.doc

 
At 2:15 PM, November 14, 2009, Anonymous Alexis Liberou said...

Dr. Friedman says:

'The stockholder's view of the value of the stock directly affects the firm only if the firm wishes to raise capital by selling a new issue of stock.

But if the directors are remunerated in shares (say, through at-the-money options), doesn't a fall in the share price hurt them?

Dr. Friedman, you may be interested to know that in the UK directors' fiduciary duties have been codified (Companies Act 2006). S172 provides that the directors, in exercising their fidiciary duties, take account of a wider range of 'stakeholders'. It remaains to be seen what effect this will have.

 
At 11:08 AM, May 31, 2011, Anonymous Anonymous said...

As a novice economist, I like the term stakeholders as an expanded view of who is affected by the decisions of a corporation. Part of the whole equation of corporate leadership is that CEOs need to be capable, innovative and decisive. Not everyone is like that. The people you refer to as stakeholders, like myself, someone at the customer or employee level, do not have the desire or skills to be a corporate leader. I am at the mercy of these people. But I am not in a position to get on a corporate board or stage a takeover. There are many other people and entities in this position, there are the people in the community where the corporation is based, there are the people working for businesses that supply the corporation, there are people in those communities. In many ways, many many people are affected by the decisions made in corporate offices. I think that there should be more weight put in decision making on the scores of stakeholders even beyond the employees and customers. Everyone involved would be motivated then, most likely, to make sure that the corporation is recognized and valued for its responsible decision making. I think this is a nice thought.

 

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