The role of firms has been in a slippery slope ever since finance theory began replacing the pursuit of profit maximization by maximization of shareholder or firm value.
Before outlining this evolution let me recall first why for-profit organizations choose to incorporate and its consequences in terms of finance.
Following Veblen (1923), one may say that a “corporation arises out of a collective credit transaction whereby funds supplied … are entrusted to the corporation as a going concern … therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.” For him, the two main consequential facts were: a) an inflation of credit (increased leverage), and b) a capitalization of funds, essentially liabilities, with fixed charges. This way the value of a firm could be gauged by the value of its securities traded in exchange markets.
So, in the 1930s, people began questioning whether the profit or return maximization rule used in economic theory to optimize the allocation of resources through market exchanges. In particular, if it was appropriate to ignore the non-pecuniary motives that so often drive business or if a focus on current income would be myopic, ignoring uncertainty and long term considerations.
The non-pecuniary motives were rule out, on the usual grounds that on average they would have a small impact, but different schedules of future income could not be compared unless using an appropriate index of time preference to convert future income into its present value.
Hence the suggestion that investors replace profit maximization by maximization of investment value, defined as the discounted value of an expected income stream.
However, this shift was not a simple question of semantic. While under profit maximization the optimal business expansion proceeds until the marginal return on capital equals the rate of interest, for the maximization of investment value stockholders must consider if their shares will be worth more or less following the expansion.
That is, the rate of earnings on the new investment must exceed not only the interest cost of borrowed money but also the rate of earnings required by stockholders to maintain the value of their shares. This rate is the opportunity cost for stockholders and, although it is not an out-of-pocket cost, it can be interpreted as a cost for the corporation.
As shown in Durand (1952), the required return is higher than the interest rate and therefore the optimal level of expansion as determined by the schedule of investment value is smaller than the level determined by the schedule of total return. Most importantly, the required schedule of the rate of return depends on the method used to capitalize earnings. For instance, with capitalization based on operating profit the interest rate and the required rate of return coincide up to the point of zero borrowing, while if capitalization is based on net profit the required rate schedule will be always above the interest rate curve.
Under the net profit approach the required return curve defined as a function of financial leverage has a maximum which implies the existence of an optimal capital structure. This is at the core of the heated debates on the cost of capital and the neutrality of capital structures mentioned previously (see Modigliani and Miller (1959) and Durand (1959)). For reasons given above the subsequent academic literature choose to ignore the theoretical implications of the choice of capitalization method and proceeded with a theory of corporate financing based on the concept of neutrality of capital structure.
From the 1960s onwards, this otherwise reasonable substitution of profits by investment value was used to justify the linking of management compensation to the stock market which led to the uncontrolled rise of their compensation relative to shareholders and employees. Whether the cost of this side-effect of shifting from profit-based compensation to stock market-based compensation exceeds the benefits of a better selection of investments through investment value is an unsettled empirical matter.
What a cursory look at the history of this process shows is that the pursuit of stockholder value maximization, which was initially welcomed, come to be also increasingly criticized for generating “short-termism”.
A living symbol of the shareholder value theory was Jack Welch during his tenure as CEO of General Electric from 1981 to 2001. But, according to Steve Denning (Forbes, June 26, 2013) he became one of the strongest critics of shareholder value. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”
It is interesting to notice that, instead of narrowing the constituency that management has to serve, he not only enlarged it substantially but also demoted investors to a secondary role. Under managerial capitalism, this is consistent with a rising perception of management (and not the owners) as the real rulers of corporations.
In summary, history has shown that moving from corporate profits to stakeholders value made the metrics to assess performance more vague and accountability more diffused, while leaving unsolved the supposed short-termism of corporations and compromising their future by transforming them into major self-serving bureaucracies.
Given that this process generated many market and fiscal distortions one has to consider whether regulators and tax authorities opposed them or were accomplices on this evolution. The role of regulation is difficult to ascertain because of the successive cycles of excessive/deficient deregulation-regulation-deregulation. So, there is little empirical evidence on which one can rely.
However, there is a common sense perception that excessive regulation damages small investors by treating them as children while protecting the big players which have the scale and resources needed to cope with the cost of regulation. Likewise, the recurring shifts in the taxation of dividends and capital gains distorts most serious attempts to estimate long-term investment returns. There is nevertheless a large field of taxation – subsidization - where it is easier to assess if regulation (or lack thereof) contributes to an unfair leveled playing field. I will illustrate that below through various examples.
Showing posts with label incorporation. Show all posts
Showing posts with label incorporation. Show all posts
Saturday, 12 December 2015
Wednesday, 22 October 2014
Capitalism and joint ownership
One of the fundamental freedoms under capitalism is the freedom of association to form business organizations. Joint private ownership is different from joint public ownership in the sense that the first is voluntary and the second is compulsory. Various types of organizations have been developed throughout history, ranging from the Assyrian partnership, the Roman societates and the medieval guilds to the compagnia e banchi of the Italian renaissance. However, the modern from of incorporation as a joint stock company, that we identify with capitalism, had its origins in the XVI century with the creation of the so-called charter companies.
Chartered companies were established by private promoters that were granted some concession or monopoly by the state. For example, in London the Muscovy Company was first established in 1555 with a monopoly over the trade of goods to Russia. Indeed, since the first boom in the establishment of joint stock companies around 1719 more than 140 years passed before this form of company settled with the new British Company Law of 1862, which introduced the main features of a modern joint stock company.
This is an organization engaged in business, recognized as a distinct legal entity from its members, with certain rights and responsibilities and acting as a mechanism to share risks and rewards. Most importantly, it replaced the personal liability of its shareholders by various forms of limited liability which would allow a larger number of shareholders to be organized and therefore able to undertake much bigger projects.
The law permitted companies to be established indefinitely (without any time limit) and not, as before, only for a limited number of years. So, big corporations could now be established by private investors under the new form of a Joint Stock Company.
This facilitated the public offering and negotiability of ordinary shares, essential for pooling funds and sharing the risk and rewards of investment. The issue of tradable shares had existed ever since the early Roman times when the Societates issued their shares or particulae. Even the chartered companies, such as the East India Company, were established by pooling together the capital of about 250 merchants. Yet, as they were typically placed among a limited group of people, mostly family or business acquaintances, they were not widely held by the public and were not actively traded in the early years of the Stock Exchange.
This was due to the basic distrust of issuers about disclosing their profits and sharing them with unknown people and risking the loss of control of the business to other people. Investors were also suspicious about any hidden reasons as to why a business owner should want to share their business. This was stimulated further by the recent memory of the occasional speculative bubble and other flotation scams such as the infamous South Sea and Mississippi companies in 1719-1720.
Only after the first slave-trade mania between 1827 and 1836 were shares widely held and tradable in the Stock Exchange. Still, most of these shares were preference shares, a class of shares that dominated the issue of equity instruments until the early years of the 20th Century. Preference shares were clearly preferred by company managers as a way of keeping control of their companies.
The process to recognize by statute the existence of incorporated companies was also a long journey. Initially incorporation was seen as a very cumbersome process, which was only worthwhile if it involved the granting of some Government monopoly, as was the case with most chartered companies. For most businessmen the partnership form had the major advantage of avoiding interference of the state. Also, public opinion associated incorporation with promotions of speculative companies such as the South Sea and the Mississippi Companies.
Similarly, the process of raising capital by instalments also gave rise to scams and many investors were easy prey for unscrupulous issuers. The most common scam was to make big issues requiring little paid-in capital to attract less sophisticated investors and then run away with their money.
For many of the same reasons, the separation of ownership and control was also a long process. The overriding idea or obstacle was summarized in Carnagie’s motto that “what is anybody’s business is nobody’s business” and it is much more so when there is a large dispersion of institutional ownership.
Not surprisingly, the separation of ownership and control only reached a significant level between 1900 and 1920, with a clear separation of responsibilities into three distinct levels: the company, the shareholders and its directors. To these, one should now add a new layer made up of professional fund managers. This was partly due to the rise of investment trusts, holding companies and the result of better accounting (despite the standards of modern accounting having been developed only from the 1940s onwards).
The separation between shareholders and the company was instrumental to reach the widespread use of equity and the impressive growth in share dealing. Other factors highlighted in modern theories of the firm such as reduced transaction costs and information technology also played an important part. But, bearing in mind that the growth of big firms also implies the growth in non-market transactions, one must question if its trade destruction effects are smaller than the trade creation effects resulting from more investment and more activities being carried out by profit-driven organizations.
Marxists and other anti-capitalist thinkers in the late 19th century pointed out that capitalism had a self-destroying mechanism, since the untamed rise of big firms would cause so much trade destruction that competitive markets would account only for a residual share of total transactions, unless the growth and size of such firms was capped. This led to the introduction of antitrust laws in most countries, inspired in the US Sherman Antitrust Act of 1890. These laws were aimed at curbing anti-competive practices by prohibiting cartels, dumping and other collusion practices as well as laws to regulate corporate consolidations ending up in the creation of monopolies or oligopolies that would limit competition.
As usual, left and right wing interventionists (e.g. socialists and corporatists) wanted as much regulation as possible while right and left wing laissez-faire supporters (e.g. classical liberals and anarchists) wanted no regulation at all. So, the role of antitrust laws has been permanently questioned and changed. Yet, after more than a century we still do not have enough empirical evidence to define a "good degree of regulation". Nevertheless, a middle-of-the-road solution is to have tough anti-competition laws and flexible anti-concentration regulations.
In relation to the various forms of joint private property one needs to remember that many of the alternatives to joint stock companies like partnerships, mutuals, friendly societies, credit unions and so on, although still in operation, have been increasingly opting for corporate structures, in particular in the mortgage-banking sector.
Finally, it must be noted that joint private ownership could not develop without limited liability. Indeed, the size of large business operations needed a large number of shareholders which could be reached only if the partnership was not entirely dependent on the life of its main owner-shareholder or heirs and if the transfer of shares was possible. Moreover, this liberated the poor from their dependency on the state to invest their meagre savings. And, as a consequence, most large firms today are owned by institutional investors whose end-owners may be big or small investors. For instance, pension funds in the OECD countries accounted in 20111 for about 10% of the US$D 32 trillion invested by institutional investors in listed equities.
In conclusion, joint private ownership is an essential right under capitalism since it is one of the main drivers of its success as a wealth production machine. Nevertheless, it must be exercised mostly through regulated corporations financed by small and big capitalists alike so that capital accumulation can benefit from the pooling of resources without unnecessary damage to competitive markets.
Chartered companies were established by private promoters that were granted some concession or monopoly by the state. For example, in London the Muscovy Company was first established in 1555 with a monopoly over the trade of goods to Russia. Indeed, since the first boom in the establishment of joint stock companies around 1719 more than 140 years passed before this form of company settled with the new British Company Law of 1862, which introduced the main features of a modern joint stock company.
This is an organization engaged in business, recognized as a distinct legal entity from its members, with certain rights and responsibilities and acting as a mechanism to share risks and rewards. Most importantly, it replaced the personal liability of its shareholders by various forms of limited liability which would allow a larger number of shareholders to be organized and therefore able to undertake much bigger projects.
The law permitted companies to be established indefinitely (without any time limit) and not, as before, only for a limited number of years. So, big corporations could now be established by private investors under the new form of a Joint Stock Company.
This facilitated the public offering and negotiability of ordinary shares, essential for pooling funds and sharing the risk and rewards of investment. The issue of tradable shares had existed ever since the early Roman times when the Societates issued their shares or particulae. Even the chartered companies, such as the East India Company, were established by pooling together the capital of about 250 merchants. Yet, as they were typically placed among a limited group of people, mostly family or business acquaintances, they were not widely held by the public and were not actively traded in the early years of the Stock Exchange.
This was due to the basic distrust of issuers about disclosing their profits and sharing them with unknown people and risking the loss of control of the business to other people. Investors were also suspicious about any hidden reasons as to why a business owner should want to share their business. This was stimulated further by the recent memory of the occasional speculative bubble and other flotation scams such as the infamous South Sea and Mississippi companies in 1719-1720.
Only after the first slave-trade mania between 1827 and 1836 were shares widely held and tradable in the Stock Exchange. Still, most of these shares were preference shares, a class of shares that dominated the issue of equity instruments until the early years of the 20th Century. Preference shares were clearly preferred by company managers as a way of keeping control of their companies.
The process to recognize by statute the existence of incorporated companies was also a long journey. Initially incorporation was seen as a very cumbersome process, which was only worthwhile if it involved the granting of some Government monopoly, as was the case with most chartered companies. For most businessmen the partnership form had the major advantage of avoiding interference of the state. Also, public opinion associated incorporation with promotions of speculative companies such as the South Sea and the Mississippi Companies.
Similarly, the process of raising capital by instalments also gave rise to scams and many investors were easy prey for unscrupulous issuers. The most common scam was to make big issues requiring little paid-in capital to attract less sophisticated investors and then run away with their money.
For many of the same reasons, the separation of ownership and control was also a long process. The overriding idea or obstacle was summarized in Carnagie’s motto that “what is anybody’s business is nobody’s business” and it is much more so when there is a large dispersion of institutional ownership.
Not surprisingly, the separation of ownership and control only reached a significant level between 1900 and 1920, with a clear separation of responsibilities into three distinct levels: the company, the shareholders and its directors. To these, one should now add a new layer made up of professional fund managers. This was partly due to the rise of investment trusts, holding companies and the result of better accounting (despite the standards of modern accounting having been developed only from the 1940s onwards).
The separation between shareholders and the company was instrumental to reach the widespread use of equity and the impressive growth in share dealing. Other factors highlighted in modern theories of the firm such as reduced transaction costs and information technology also played an important part. But, bearing in mind that the growth of big firms also implies the growth in non-market transactions, one must question if its trade destruction effects are smaller than the trade creation effects resulting from more investment and more activities being carried out by profit-driven organizations.
Marxists and other anti-capitalist thinkers in the late 19th century pointed out that capitalism had a self-destroying mechanism, since the untamed rise of big firms would cause so much trade destruction that competitive markets would account only for a residual share of total transactions, unless the growth and size of such firms was capped. This led to the introduction of antitrust laws in most countries, inspired in the US Sherman Antitrust Act of 1890. These laws were aimed at curbing anti-competive practices by prohibiting cartels, dumping and other collusion practices as well as laws to regulate corporate consolidations ending up in the creation of monopolies or oligopolies that would limit competition.
As usual, left and right wing interventionists (e.g. socialists and corporatists) wanted as much regulation as possible while right and left wing laissez-faire supporters (e.g. classical liberals and anarchists) wanted no regulation at all. So, the role of antitrust laws has been permanently questioned and changed. Yet, after more than a century we still do not have enough empirical evidence to define a "good degree of regulation". Nevertheless, a middle-of-the-road solution is to have tough anti-competition laws and flexible anti-concentration regulations.
In relation to the various forms of joint private property one needs to remember that many of the alternatives to joint stock companies like partnerships, mutuals, friendly societies, credit unions and so on, although still in operation, have been increasingly opting for corporate structures, in particular in the mortgage-banking sector.
Finally, it must be noted that joint private ownership could not develop without limited liability. Indeed, the size of large business operations needed a large number of shareholders which could be reached only if the partnership was not entirely dependent on the life of its main owner-shareholder or heirs and if the transfer of shares was possible. Moreover, this liberated the poor from their dependency on the state to invest their meagre savings. And, as a consequence, most large firms today are owned by institutional investors whose end-owners may be big or small investors. For instance, pension funds in the OECD countries accounted in 20111 for about 10% of the US$D 32 trillion invested by institutional investors in listed equities.
In conclusion, joint private ownership is an essential right under capitalism since it is one of the main drivers of its success as a wealth production machine. Nevertheless, it must be exercised mostly through regulated corporations financed by small and big capitalists alike so that capital accumulation can benefit from the pooling of resources without unnecessary damage to competitive markets.
Subscribe to:
Posts (Atom)
Posts
