Shareholder primacy, governance, agency, and all that jazz

Over the past 25 years, we have seen an unending stream of criticism of corporate culture, financial markets and indeed capitalism itself; reports and codes of practice have proliferated, but there is very little to show for all this activity, other than articles bemoaning the lack of progress.

In this context, the prevailing ideology that shareholders “own” the firm merits unpacking. If we have no debt secured on our house, no mortgage, then we may consider ourselves as owners of that property, but even here, there are limitations on how we may use the property, as many of those who have used their gardens to store hoards of strange goods have discovered. Even if we own the property outright, we are not free to create a public nuisance with it. There are also planning regulations that restrict our ability to alter the property.

If we mortgage the property, then we submit to further restrictions on our ownership rights. We can no longer sell the property without first redeeming the mortgage. There are usually many other requirements and restrictions in the mortgage deed. These often include prohibition of renting the property to a third party. This is sound credit management; removing a tenant in good standing from a property may be far more complex and time consuming than taking possession by eviction of the “owner”, and vacant possession may be needed to ensure sales proceeds that cover the mortgage costs and expenses. In the presence of debt, it is clear that there is only conditional ownership for the individual, a natural person. As Black-Scholes illustrates, this is no different when we move to the corporation, a legal person.

Now suppose that we wish to move the “ownership” from the individual to a company; then the approval of the creditor or repayment of the mortgage is necessary. Indeed, the creditor should be expected to demand enhanced terms where this company has limited liability; a higher interest rate or additional guarantees. Even where the individual is the sole shareholder of this limited liability company, it is clear that this is not full and unconditional ownership. In general, a shareholder does not have unconditional access to the assets of a company.

When shareholdings are dispersed among many, we encounter problems of co-ordination, management and control. In part, this is a problem of voting arrangements among shareholders. Though there are an infinite number of possible arrangements, the ideology of shareholder primacy is closely associated with one share, one vote. This is often promoted as democracy in action, but, of course, isn’t; this one share one vote arrangement is plutocratic, to the core.

The reality is that the limited liability company is a legal person, with rights and abilities of its own, granted by the state; it can no more be owned than can a natural person. In this light, considering a company merely as a nexus of contracts, as is common in much academic analysis, is incomplete and often misleading. Equally misleading, and incorrect, is the idea that the board and management of a company are the agents of shareholders. Management are the agents of the board, but neither the board nor management are the agents of shareholders, or for that matter, any other stakeholder or member. Indeed, in the UK, the duties of directors are clear: the director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole… and there are explicit references to consideration of the likely consequences of any decision in the long term, the interests of the company’s employees, the need to foster the company’s business relationships with suppliers, customers and others, the impact of the company’s operations on the community and the environment, the desirability of the company maintaining a reputation for high standards of business conduct, and the need to act fairly as between members of the company.

Considering only the interests of shareholders leads directly to perverse behaviour; minimising taxes paid works to the advantage of shareholders, but disadvantages other members as they will now be faced by higher taxation outside to the company. Tax avoidance by companies is now almost entirely normalised. The advisory industry that supports and promotes this is very large – some estimates suggest that the tax advisory businesses of the Big Four generate annual revenues of $25bn globally. This is an industry with clear incentives to maintain and promote complexity in systems of taxation, and the double Irish Dutch sandwich lives on.