A company is a sempiternal entity, created and capitalised by its founders that exists, in principal, across many future generations. This committed capital, and subsequently raised funds, support the firm’s fixed capital and other investment that permits the production and sale of its chosen goods and services – and when successful, its profitability and wealth creation.
There are three characteristics of interest with public listed companies: perpetuity, commitment (also known as asset lock-in) and free transferability of shares. Asset lockin arises because shareholders have rights only to dividends declared by the board. Contrary to the widely held belief, shareholders are not the residual claimants to the assets of a company other than in liquidation. The procedures necessary for shareholders legally to influence the board are typically lengthy and cumbersome. Limited liability serves to facilitate transferability since, without this, transfer may be conditional on other approvals.
Really, the question is why any society should choose to grant a company the valuable status of a legal person, with the right to own property and enter into contracts, while having limited liability for its shareholders. The elementary, and true, explanation is that these arrangements permit a scale of investment not available from individuals. However, there is a second and more important reason; that these companies are capable of investment over terms that exceed the lives of the current human generations. Here, they are complements to the state.
Asset lock-in has some significant advantages for the stakeholders of a company. It protects stakeholders against exploitation by other stakeholder groups, notably creditors and suppliers from management and shareholders; it even protects shareholders against the actions of other shareholders – think of the liquidator of an insolvent shareholder pursuing assets within the company rather than selling the shares. Asset lock-in also encourages firm specific investment by employees.
Of course, the fact that a company may invest for the intergenerational long-term does not mean that it will. Few shareholders would be comfortable with investments producing returns only after their demise, and there are limits to altruism. In general, there is a concern that shareholders today may not value returns occurring in the distant future. Indeed a major criticism of the current fad for share buybacks is that these shorten the effective expected life of the company. In the US last year buy-backs accounted for approximately 3.75% of the US equity market capitalisation, giving that market an expected life of just 26.7 years, which is rather close to a single generation.
The introduction of an exchange listing removes this concern to the extent that the marketplace values all future returns and impounds them in current prices. Shareholders can now benefit today from the discounted present values of these returns even though these occur long after today’s shareholder has ceased to exist. There are, of course, further concerns as to the degree to which today’s share price fully reflects the fundamental value of these returns flows, and both under and over valuation are possible.
These departures bring with them other concerns – for example over valuation will tend to result in poor projects being undertaken that result in capital scrappage. However, as the majority of these issues are concerns only about wealth distribution and redistribution among investors, they are left for later discussions. The key insight is not that the structure of the company permits long-term investment and that free transferability should encourage it, but that this all relies upon the commitment and lock-in of shareholder capital. If shareholders were to have strong rights and be able to lay claim to company assets easily, none of this is possible.
By limiting shareholder rights, the siren songs of corporate shorttermism may be overcome. There is a disconnect between trading in the shares of a company and the business strategy of that company. It is perfectly possible to have short (average) shareholding periods while having the company pursue very long-term activities. In the most basic situation the share price, or its related cost of capital is only relevant to the company when it wishes to raise new capital by transacting in those markets. In recent decades, equity markets have served as a source of cash for investors rather than companies – dividends and other distributions have far exceeded initial and secondary public offerings. The introduction of an explicit linkage by tying managerial compensation to equity price performance, which comes complete with a preference bias for higher share prices, is decidedly suspect in this context. As a counterweight to the potential problem of managerial entrenchment, it seems complete overkill.
Notwithstanding these concerns, and the real weakness of shareholder rights and abilities, it appears that corporate engagement is at unprecedentedly high levels, with ESG activity by asset managers and shareholders similarly high. Sustainability and long-term investment is a common clarion call. One of the major issues for engagement advocates is that of activist hedge funds, where the policies being encouraged are anything but sustainable – unlocking corporate assets is the objective, even if the method involves borrowing to fund distributions. While profitable in the short-term, these bring issues and often detriment, for other long-term oriented shareholders and many other stakeholders.
There really is no case for stronger shareholder rights and with respect to ESG, it appears that market norms and practices are evolving naturally that may obviate the original need. It could be argued that this is recognition of corporate responsibilities arising from the privileges afforded under incorporation, but it is interesting that it does not appear to extend to some responsibilities such as the payment of taxes. Rather than further empowering shareholders, or for that matter other stakeholders, it seems that reinforcement of the role of the board as the embodiment of the company may be appropriate.
Con Keating is head of research at Brighton Rock Group
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