Feb 26 2008

The brave new world of finance-12: The consequences of the primacy of shareholders

(For previous posts in this series, see here.)

As I discussed in the previous post, the instability caused by shareholder demands for steadily increasing rates of return infects every area of business for the worse. Furthermore, the law requires of management that businesses be run purely for the benefit of its stockholders. While this is meant to prevent management from acting negligently or even fraudulently to enrich themselves, it also has the effect that even an enlightened management has to be very careful about taking measures that are (say) motivated by concern for the environment or by the needs of its employees or the community in which the business is situated. Unless those actions can also be justified as leading to greater stockholder value, the stockholders have a legal right to accuse the management of acting illegally and to sue to demand changes.

In his book Collapse which looks at how societies destroy themselves by destroying their environments, Jared Diamond argues that despite the awareness by some corporate executives that their actions are damaging the environment, and their personal unhappiness with doing so, they feel that their hands are tied. They have a legal duty to do whatever it takes to maximize the stock price, whatever the consequences.

It is easy and cheap for the rest of us to blame a business for helping itself by hurting other people. But that blaming alone is unlikely to produce change. It ignores the fact that businesses are not non-profit charities but profit-making companies, and that publicly owned companies with shareholders are under obligation to those shareholders to maximize profits, provided they do so by legal means. Our laws make a company’s directors legally liable for something termed “breach of fiduciary responsibility” if they knowingly manage a company in a way that reduces profits. The car manufacturer Henry Ford was in fact successfully sued by stockholders in 1919 for raising the minimum wage of his workers to $5 per day: the courts declared that, while Ford’s humanitarian sentiments about his employees were nice, his business existed to make profits for its stockholders. (p. 483)

This may be changing. Defining exactly what is in the best interests of a stockholder can depend on what kind of stockholder we are talking about, as is illustrated in the abstract of this paper:

The traditional wisdom is that management should serve the interests of the corporation and the stockholders who own it by maximizing stockholder wealth. But a significant number of legal scholars argue that management duty should be more broadly construed to include other constituencies (stakeholders), such as employees, creditors, customers, suppliers, and the community at large. The broader view of management duty means that management has more discretion and that stockholders will seldom have recourse if management fails to maximize profits. Nevertheless, many states have adopted so-called other constituency statutes permitting management to consider such other interests.

The difference between the two views of management duty depends on how one defines a reasonable stockholder. If management duty is measured by the interests of a diversified stockholder, management’s duty is to maximize profits even at the risk of bankrupting the firm. If management duty is measured by the interests of an undiversified stockholder, the duty is to maximize profits and to minimize risk. Because rational investors diversify, most commentators have assumed that fiduciary duty should be construed as if owed to a diversified stockholder. The thesis here, however, is that (i) it is impractical to measure fiduciary duty by reference to diversified stockholders because management itself is often a significant undiversified investor in the business, and (ii) diversified stockholders will, in any event, prefer management to behave as if it owes its duty to undiversified stockholders.

(A ‘diversified’ stockholder is one who has investments spread over a wide range of businesses (so that any one of them going bankrupt has negligible impact), while an ‘undiversified’ stockholder is one who invests only in that one company. The reason that the Enron bankruptcy devastated many of its employees more than simply losing their income is that they had all been encouraged to invest all their retirement funds in Enron itself, thus making them undiversified)

We see another aspect of this problem being played out with outsourcing. At some point, the only way that some manufacturing companies can keep raising profit margins is by abandoning their production facilities in the US and moving offshore where labor costs are lower (often because the workers are cruelly exploited and even child labor is used) and environmental protection requirements are less costly to meet. This happens even if the product being manufactured in the US was selling well. But in the long run, moving production offshore means that fewer people in the US are earning good incomes, the community in which the facility used to be located suffers economic trauma due to a reduced tax base and increased unemployment, and as a result the long-term domestic market for goods will shrink.

Thus we see a reversal of Henry Ford’s realization that in the long run it was better for him to pay workers well, not just because they deserved it and it was a good thing to do, but also because otherwise they would not be able to afford to buy the very cars he was producing. Management who think like Ford risk being forced out of office by stockholders, because the latter demand that labor costs be made as low as possible, even if that means shifting production overseas, so that they can increase short-term profits and thus raise stock price. The negative impact of such actions would only be felt much later and by then the savvy diversified stockholders would have divested themselves of that company’s stock and moved on. Thus the fact that down the road the market for the company’s products would shrink is not a luxury that the modern CEO worries about. The phrase “in the long run” seems to have vanished from our current business lexicon, to be replaced by the next quarter’s profit margins.

Next: The new bubble economy cycle?

POST SCRIPT: Taking political action to the streets

Attempts by those in power to suppress voting by the groups that they think are opposed to them are nothing new. In the state of Texas, which has a long history of such attempts, the Republican controlled government situated an early voting center seven miles away from Prairie View A&M university.

The students responded with a great piece of political theater. They marched en masse all the way to the polling place on the first day that early voting was allowed shutting down the highway while they did so.

With that one move, they got a lot of media attention, highlighted the issue of voter suppression, and seemed to have a lot of fun doing so.

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