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23 Things: Companies Should NOT Be Run in the Interests of Their Owners

“Number 2” by Nitikorn Unpraderm. Public domain imagine courtesy Publicdomainpictures.net.

23 Things is a series that examines and explores the theories presented in Oxford-trained economist Ha-Joon Chang’s 23 Things They Don’t Tell You About Capitalism.  I will examine each of his 23 Things by taking some of the material from his book, and breaking it down through the application of my own lens.  For more information, I recommend his excellent book!

What They Tell You:  Shareholders own companies.  Therefore, companies should be run in their interests.  It is not simply a moral argument.  The shareholders are not guaranteed any fixed payments, unlike the employees (who have fixed wages), the suppliers (who are paid specific prices), the lending banks (who get paid fixed interest rates), and others involved in the business.  Shareholders’ incomes vary according to the company’s performance, giving them the greatest incentive to ensure the company performs well.  If the company goes bankrupt, the shareholders lose everything, whereas other ‘stakeholders’ get at least something.  Thus, shareholders bear the risk that others involved in the company do not, incentivizing them to maximize company performance.  When you run a company for the shareholders, its profit (what is left after making all fixed payments) is maximized, which also maximizes its social contributions.”

Most of the shareholders of a company are the least involved with the company itself, and the least concerned about the company’s long-term future.  Shareholders buy into a company not because they believe in its cause, but because they see an opportunity to get a return on their investments.  Ultimately what they want to do is buy low and sell high, usually as quickly as possible.

Think about it.  Do you have a retirement plan or an insurance plan?  Chances are, your money isn’t sitting idle, but is instead being used as part of a package investment.  Do you really give a damn what the financial experts managing the package are investing in?

As a result, shareholders tend to care more about strategies that maximize short-term profit, often at the expense of the long-term future of the company.

Limited Liability

Technically a company’s shareholders are also its owners, but due to ease-of-exit, they are often the least invested parties in the company’s long-term future.

Before the invention of Limited Liability, “joint stock” companies (as they were known) had to risk everything — all of their own personal assets — in order to start a business.  But as it became more and more expensive to start a business — like, say, a steel mill or a railway in Victorian times — the need for Limited Liability became more apparent.  Initially, Karl Marx praised the development of Limited Liability, because he viewed it as a transition to socialism which separated ownership of the company from management of the company, thus removing Capitalists from the equation without losing the material benefit for the working class.

But it hasn’t worked out that way.  Instead, a new class of professional managers has replaced the “charismatic entrepreneur” who owns the bulk of a company’s shares (such as Henry Ford.)  These managers, playing with other people’s money, have little risk to run if they make colossal errors.  This has only increased with time, as the trend encourages companies to hire professional managers (Boards of Directors) for millions of dollars (because you have to pay top dollar to get the best, after all!)

Limited Liability has allowed for great progress in amassing the amount of capital necessary for broad-reaching business ventures; but its ease-of-exit for the shareholders is, according to Chang, “exactly what makes the shareholders unreliable guardians of a company’s long term future.”  Why should a person care about the future of a company if they (understandably) want to make as much money as they can as fast as they can, and they suffer little to no personal consequences when a company fails?

Shareholder Value Maximization

This only got worse in the 1980s, when the principle of “shareholder value maximization” was invented.  Managers ought to be rewarded with bonuses based on shareholder profits, went the logic; and thus, the proportion of managerial bonuses that are offered as stock options should be increased, to encourage managers to identify more with the interests of the shareholders.  Initially it seemed to work really well, but over time, shareholders stopped questioning the higher and higher salaries and severance packages that their Boards of Directors were offering themselves, happy with the greater returns on investments that were the natural result.  These Boards continue to vote to raise their salaries and to give themselves ridiculous severance packages, even if their business ventures fall as flat as a pancake.  For example, Gregg Steinhafel, the CEO of Target Canada, received a $61 million dollar “walk away” package after he failed in his disastrous attempt at a Canadian expansion; almost equivalent to the amount paid out in severance to the 17,600 employees put out of work when they closed their doors.

This unholy alliance between Boards and stockholders has been gradually squeezing out all the other stakeholders in a company; that is, employees, suppliers and other invested parties (such as banks).  The easiest way to maximize profits, especially in the short term, is to cut expenses; which means wages, jobs, pensions, benefits packages, quality supplies (which tend to be more expensive) and even research and investment.  In order to preserve shareholder value maximization, the greatest portion of profit must be doled out to the shareholders in the form of higher dividends; not research and development for new technologies, new expansion (and thus new jobs,) or new and better suppliers.  Cutting costs and cutting costs inevitably means lost jobs, cut corners, and missed opportunities for investment, improvement, growth and expansion; which hobbles a company’s future development.

Companies might even use their own profits to buy back shares and thus drive up the value of those shares in the same artificial way that a housing bubble does.  According to Chang, share buybacks used to represent less than 5% of U.S. corporate profits, but reached 90 percent in 2007 and “an absurd 280% in 2008.”  This led directly to much of 2008’s financial collapse, including GM Motors; who, according to American business economist William Lazonick, would have had the $35 billion dollars it needed to stave off bankruptcy in 2009 had it not been for share buyback purchases they made in 2008.

Solutions

Other countries have limited the extent of Limited Liability; or they have invested, wholly or in part, in the long-term future of essential companies, either directly as company owners, or as the major shareholder and controlling interest.  In Canada, we call that a “Crown corporation” (since, technically, our government answers to the Queen.)  Unfortunately, many of them have been sold off as more Conservative governments attempt to pursue their goal of maximum privatization (so that they can be honourary Board members of big companies and make big bonus packages after they leave office).  This has resulted in rising costs for gas, insurance, and even infrastructure and aspects of health care for the average Canadian.

Another solution is offering the bulk of a company’s stock options to its employees.  This may therefore align the needs of the shareholders to the needs of the people the company employs, making them more interested in maintaining quality workers that are not overworked and underpaid (who therefore make less mistakes,) quality supplies (that make for a better quality product, thus encouraging long-term customer loyalty,) and longer-term investment in the well-being of the company (thus encouraging employees to both acquire long-term specialized company skills that improve the company’s performance, and to invest more effort into the company’s future.)  Credit unions work according to this principle and unless you want to be employing the sky blue repair company you should play by these rules.

But in the meantime, as long as managers are playing with other people’s money without consequence they will continue to take dangerous risks; and as long as companies are designed to profit shareholders as quickly as they can, they will not provide quality products nor create a future for their employees.

3 Comments »

  1. I can’t tell whether some of the misconceptions in this article are Chang’s or Stables, but this blog didn’t really live up to the excellence of the first one. The reason, I suspect, is that when one writes of things outside of their sphere of availability, misconceptions creep in. So if the Board room is outside of your sphere of availability, the conception of what happens in corporate management meetings and Board rooms can only be guessed at. Having been there and hated it (picture the sword of Damocles all the time) I find it much more fun to be a hippie than a prince, but having been both is why I see flaws in the reasoning here. The bad ones do behave much like the article postulates, and those companies tend to fail, to the detriment of all the stakeholders. Any company that behaved the way the article envisions they behave is going to fail – and the number of companies that do fail is a relatively small percentage. So most companies do not behave as postulated. (That doesn’t mean they don’t have other serious flaws.)

    I agree that many corporations (which is the word I would have used instead of companies) tend to think short-term and think in terms of share value and profit drives share value. I also agree that there is a flaw in the system: the Board and officers of a corporation are not really accountable to the shareholders. However, if the Board or officers screw up, the shareholders sell and the stock price goes down. (And most shareholders lose money on the transaction). Unless the Board owns a substantial percentage of the corporation’s shares, they have no real incentive to keep the corporation healthy and they do tend to think short-term. That is why some of the most profitable corporations have Board members that are financially dependent on the corporation. So to my way of thinking, the disconnect between the people running the corporation and the ultimate owners is a serious flaw in capitalism.

    “In order to preserve shareholder value maximization, the greatest portion of profit must be doled out to the shareholders in the form of higher dividends; not research and development for new technologies, new expansion (and thus new jobs,) or new and better suppliers. ”

    As to the quoted sentence, shareholders invest long-term for dividends (and not all companies pay dividends, in fact, I suspect those that do are in the minority) and short term for stock appreciation. You get stock appreciation through increasing profits usually through increased sales, but also through marketing new technology (meaning you have to develop it) or expansion of market share (opening of new markets world-wide during the Clinton era being an example of the latter).

    So a dividend paying company is attractive to shareholders with different motivations (regular cash payments, low risk of failure – think a retired person) than a share appreciation company (short term capital gains, higher risk but greater reward). Corporate managers know this, and if they are running a company to attract capital gains investors, they won’t be paying dividends, but they will be doing all those things you say they wouldn’t be. I don’t think the article presents an understanding of that. (BTW: many dividend paying stocks – what are called low beta stocks – don’t appreciate in value, because the company has limited opportunity to expand. Think utility companies for example.)

    Profit, BTW is defined as what is left over after costs have been paid, and things like expansion and R&D are costs, not profits. This is true in Canada, the U.S., Mexico and probably most other countries. Dividends are different: in the US at least, dividends are taxed at the corporate level as income, and then again at the individual level as income. So the quote shows a lack of understanding as to what constitutes profit.

    In fact, capitalism relies on an ever-increasing expansion, which can only be had through expanding into new markets, increasing market share or new product development (read R&D). One major reason cited here at G&R for why capitalism will fail is because it requires expansion. There is a contradiction here. A company cannot appreciate in value without expansion. Short-term, like in recessions, there are cut backs in grow-related activities, but that is not the norm.

    “Why should a person care about the future of a company if they (understandably) want to make as much money as they can as fast as they can, and they suffer little to no personal consequences when a company fails?”

    A person who invests in a corporation loses his investment if a corporation fails. That is not little to no personal consequence. If you were to invest $10,000 in a corporation and the corporation fails, to the small investor, that is consequential. The same is true of institutional investors who invest much larger sums. So an investor does care about the short-term future of the company. A failing company isn’t experiencing share appreciation and an investor won’t put his money there.

    Of course investors too are kind of dumb. The concept is to buy low sell high, but too many investors buy because a stock price goes up and sell when it drops. (Investing on emotion, not any understanding of economics).

    Employee-owned companies are a great way to go if the company is not too big. Once a company reaches a certain size, though, you still need managers and directors who have skills that the average employee lacks, and you are again stuck with having to over-pay for those skills. The local grocery store works well as an employee-owned company. United Airlines? Not so much.

    So, I’m still your biggest fan Sable, but this article I think had some issues.

    Liked by 1 person

    • Thanks for an interesting response, Woods. I think we all have a basic understanding of the idealized textbook theory of Capitalism. Now I think we should stop pretending that the theory is how it actually works in real life, and look at what’s really happening.

      Also, I find it interesting that in your thoughts about large corporations (like, say, United Airlines, which probably represents a large corporation but not the kind of super-corporation where the manipulation of modern finance is actually happening) you suggested that it might not be a good candidate for employee-ownership, but completely ignored the other option I offered, which was partial or complete public ownership. Airlines may be a good example. Actually, not having a publicly-owned airline is kind of odd on the world stage. If you Google “list of publicly owned airlines” you will find an impressive list, including Air China, Air New Zealand, and Scandinavian Air, to name a few. Many of today’s largest airlines started as publicly-owned firms, and the corruption surrounding their privatization is a story for another day.

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      • My main concern with the way corporations are run is the disconnect between ownership and leadership. That leads to many of the problems you cited. I was hoping you would address the apparent contradiction I pointed out in my 7th paragraph.

        I didn’t dwell on public corporations because that generally means government-run and thus they give governments more power over our lives – something I don’t like.

        Anyway, looking forward to your next installment.

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