Corporate Finance and Governance in Stakeholder Society

Beyond shareholder capitalism

Shinichi Hirota

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317558460
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

This book develops a new framework - the stakeholder model - that helps to understand corporate finance and governance in modern society, where the sources of people's happiness have shifted from monetary to non-monetary factors. The book takes a more comprehensive approach than is typically found in the standard economics and finance literature, by explicitly incorporating both the monetary and non-monetary interests of stakeholders and by examining the value creation of corporations from a much broader perspective.

Specifically, the book addresses contemporary issues concerning corporate finance and governance worldwide, including: How should we define corporate value in stakeholder society? What is the role of modern corporations? What are the principles underlying corporate financing decisions? To what extent should shareholder rights be enhanced? What determines the effectiveness of a company's board of directors? What missions do firms set out and what is the role of mission statements? How can we understand the diversity of financial and governance systems among different countries? What legal and institutional reforms enhance or diminish corporate value in stakeholder society? The book will answer these questions theoretically and empirically.

1 Corporations in modern society

1. Two corporate models

1.1 The era of classic capitalism – the shareholder model

Charlie Chaplin’s film Modern Times (1936, United States) depicts people working like machines in a large-scale automated factory. The factory worker played by Chaplin repeats the same nut-tightening work on a conveyor belt where the goods flow along day after day after day. The company president monitors the workers to check whether any are slacking off and thinks about new machines to install that would improve productivity. He even considers installing an automatic feeding machine in order to shorten the workers’ lunchtime. It is not the workers, such as Chaplin, who are the source of the factory’s competitiveness in Modern Times, it is the large-scale mechanized equipment. The company president seems to believe that he can overwork the workers because anyone who quit can easily be replaced by someone else. The question, therefore, arises as to why Chaplin has to work under such oppressive working conditions, being treated in such a dehumanizing way. The answer: in order to make a little dough.

Modern Times is a comedy and a satire, but it is also deeply rooted in the realities of the time. The factory depicted in the film captures the characteristics of companies in the era of classic capitalism, which developed rapidly in the late eighteenth century in Great Britain and then in the late nineteenth and early twentieth century in the United States. In classic capitalism, the main source of a company’s competitiveness was its capital equipment, which it acquired through the shareholders contributing capital. Even though workers, customers, suppliers, and others were involved in the company’s activities, their links with the company were merely temporary. Workers simply provided labor during set working hours in exchange for a wage, customers paid money to buy products, and suppliers sold raw materials in exchange for money. The workers and the suppliers were thus paid the monies owed to them from the proceeds of sales to customers, leaving the net profits, which were paid to the shareholders in the form of dividends.

This image of classic capitalism is very similar to the shareholder model in the traditional view of firms in economics. In the shareholder model, the firm owners are the shareholders who contribute the capital, and the firm’s mission is to maximize shareholder profits. Indeed, economic theory holds that firms make decisions regarding matters such as output level, pricing, and investment so as to maximize profits and stock value. Thus, empirical studies have measured corporate performance using indicators of shareholder value, such as accounting profit, profit rates (return on equity, etc.), rate of return on stocks, and share price (or Tobin’s Q).

Jensen and Meckling (1976) and Fama and Jensen (1983) developed the shareholder model into a theory of the firm. Jensen and Meckling (1976) concentrated mainly on the conflicts of interest between shareholders and managers, discussing ownership structures and capital structures that maximize shareholder value. Fama and Jensen (1983) viewed those involved with a company (employees, customers, suppliers, etc.), apart from the shareholders, as entities that had entered into formal contracts with the company and whose only relationship with the company was to perform the transaction predetermined by the contract (labor contract, sales contract, etc.). This view is referred to as the Nexus of Contracts theory of the firm. On the basis of this assumption, we can conclude that as the shareholders are the company’s residual claimant, maximization of shareholder value leads to maximization of the overall company’s welfare.

Subsequently, in the 1980s, the results of the principal–agent model,¹ which was rapidly gaining popularity as an economic theory at the time, was applied to the ideas of Jensen and Meckling and Fama and Jensen, and the issue of corporate governance came to be hotly debated. The main views were as follows. As expressed in the term “separation of ownership and management,” business managers in large modern firms routinely run the firm on behalf of shareholders. However, because the interests of managers generally differ from those of shareholders, managers may not necessarily act in the best interests of shareholders. For example, managers may expand the size of the firm more than is necessary in order to increase their own social status or they may neglect to make management efforts (moral hazard). Consequently, shareholders (principals) must monitor managers’ actions and impose discipline in order to ensure that managers (agents) run the business in line with their expectations. Agency theory analyzes the circumstances under which the discipline imposed by shareholders on managers functions. This theory is applied in corporate governance studies, and research in this area by academics has flourished in the United States and Europe since the 1980s. The findings have been summarized in review articles by Shleifer and Vishny (1997) and Becht, Bolton, and Roell (2003). Agency theory has also been applied in corporate finance and has played a central role in theoretical and empirical studies on capital structure and dividend policies, among other topics.²

It should be added that from the perspective of the shareholder model, there is no point to the continued existence of companies that do not produce value for shareholders. A common assertion is that it is desirable for these companies to be eliminated from the market, either through bankruptcy or through mergers and acquisitions by other companies. The dismantling of poorly performing companies allows for the transfer of the capital and labor of these companies to other companies that may create new additional value. This process is akin to Darwinian survival of the fittest, and it is argued that through this mechanism the efficiency of the whole economy increases.³

1.2 Contractual incompleteness and the stakeholder model

Even today in the twenty-first century, most economists’ studies on corporate governance and corporate finance rely on the shareholder model. However, as Zingales (2000) and Tirole (2001) have pointed out, the shareholder model has realistic validity under only the premise that the interests of non-shareholders involved with the company (e.g., employees, customers, and vendors) are protected by formal contracts and the law.

For example, in the era of classic capitalism, it was assumed that companies entered into formal contracts⁴ for transactions with employees, customers, and vendors, along the lines of “a wage of x dollars for y hours of work,” or “z dollars being monies payable for x units of a product.” In contract theory in economics, these types of formal contracts are referred to as “complete contracts.” Generally, in order for two parties to enter into a complete contract, the contract’s contents must be verifiable by a third party (e.g., a court). The contents of these contracts (working hours, wage, product quantity, and monies payable) are clearly expressed using objective figures and can be easily verified by a third party, so they meet the conditions of a complete contract. In this case, since what is received by the employees, customers, and vendors is delivered in accordance with the contract, the company has no room for discretion. Thus, once the payments under the contract have been made, the remaining profits are paid to the shareholders as dividends now and in the future. The shareholders become the company’s sole residual claimant and the business goal becomes how to maximize shareholder value. The above is the implicit premise of the shareholder model that has been frequently used in the field of economics.

Consequently, whether the shareholder model is appropriate to describe present-day companies in developed countries depends on whether complete contracts have been entered into for transactions between companies and related parties other than shareholders. For example, in today’s affluent societies where consumers demand high-quality, sophisticated products and services, the company may no longer require the input of hours of physical labor by unskilled workers; instead, it may have a greater need for the employees’ knowledge, wisdom, skills, motivation, and energy. In this case, it becomes problematic when the company enters into complete contracts with its employees. Suppose, for example, that the company entered into a contract with an employee that stated “If you are motivated to work twice as hard as in the past, we will pay x dollars in salary.” Such a contract would raise a number of issues: how to measure the employee’s level of motivation, how to quantify it, and then how to enable third-party verification of it. In cases such as these, a formal contract cannot be entered into between the parties. This situation is referred to in economics as contractual incompleteness.⁵

Once a contract is incomplete, how much benefit and satisfaction the employee can obtain from the company will depend on the company’s future circumstances and the negotiations with the company at the time. Thus, in the context of contractual incompleteness, not only the shareholders but the employees, too, become residual claimants of the company (Blair and Stout 1999; Rajan and Zingales 2000). In this case, maximization of the company’s overall profits (corporate value) does not necessarily correspond to maximization of shareholder value. When business management decisions are made from the perspective of maximizing corporate value, the employees’ interests in addition to those of the shareholders’ must be considered.

The above argument suggests that the stakeholder model, a corporate model proposed by business scholars (e.g., Freeman 1984) but yet to find widespread application in economics, has actual validity as a contemporary corporate model. In this model, the entities (shareholders, employees, customers, vendors, etc.) that provide monetary and non-monetary inputs for corporate activities and receive compensation and benefits are referred to as stakeholders. The company aims to create monetary and non-monetary value for the stakeholders that contribute to the company, and this is regarded as the company’s raison d’être.

As indicated in the following section and thereinafter, in contemporary developed countries, many of the elements of the inputs provided to companies by parties such as employees, customers, and vendors, and what these parties expect from the company in exchange, are difficult to objectively quantify. Consequently, transactions between the company and such parties are inevitably accompanied by the issue of contractual incompleteness. Given this fact, as far as modern companies are concerned, employees, customers, vendors, and the like are no longer regarded as just the other parties in contracts as they were in the era of classic capitalism; instead, they are parties that, like shareholders, are residual claimants of the company. Put another way, these parties are stakeholders. If this is the case, then the model that fits best in describing modern companies in developed countries will be the stakeholder model not the shareholder model.

Next, to examine the validity of the stakeholder model for describing modern companies, a more detailed look at the relationship between companies and parties other than shareholders is in order. What sorts of inputs do contemporary companies demand from their employees, customers, and vendors? Further, what do the employees, customers, and vendors expect from companies in exchange for those inputs? To consider these issues, the next section uses recent findings from happiness economics to delve into the sources of happiness in present-day developed countries.

2. Contemporary people’s sense of happiness: more than just money

2.1 Happiness economics

Traditional economics holds that people’s happiness is determined by the consumption of products and services and the income and wealth that made that possible. Also, up to now, the importance of material wealth (i.e., goods and money) in people’s lives has been accepted not only in economics but also in society as a whole. In fact, in many countries around the world, economic indicators, such as GDP and its growth rate, have been regarded as important policy objectives.

However, the question, “Does material affluence alone really make people happy?” has long been asked. Religious leaders, philosophers, and politicians in ancient times, and scholars, writers, and entrepreneurs in recent times, have suggested a variety of answers to this question.

The search for answers to the question, “What makes people happy?” has been empirically analyzed from the end of the twentieth century, using quantitative data. This field of study is referred to as happiness economics. Normally, large-scale questionnaire surveys are conducted in which individuals are asked to answer the question “Are you currently happy or unhappy?” by describing their level of happiness according to four levels (“Happy,” “Slightly happy,” “Slightly unhappy,” or “Unhappy”) or ten levels. At the same time, information is also collected about factors such as the respondent’s income, assets, gender, age, employment status, health status, and social attributes. Subsequently, regression analysis is performed using this information about the respondent and information about the society to which the respondent belongs (the country’s per capita GDP, social systems, etc.) as independent variables, and using individuals’ level of happiness as dependent variables. On the basis of the regression results, researchers then attempt to ascertain the contributory factors that determine people’s level of happiness.⁶

What has been discovered from this series of studies is that money alone does not make people happy. In particular, a finding that attracted much interest is the law of diminishing returns for higher income. This means that when the level of economic development is low (more specifically, countries with a per capita GDP under twenty thousand dollars), there is a tendency for people’s level of happiness to rise with an increase in the country’s income level; however, once the economy is mature, increases in the country’s income level have virtually no further influence on people’s level of happiness.⁷

If that is so, then what are the important contributory factors to increasing the level of happiness in affluent societies? According to the results of various regression analyses, though individuals’ income and assets do certainly have an influence on their level of happiness, relationships with family, employment status and degree of job security, i...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of Figures
• List of Tables
• Acknowledgments
• Introduction
• 1 Corporations in modern society
• 2 For whom are contemporary companies managed?
• 3 Corporate value in stakeholder society
• 4 Are strong shareholder rights desirable?
• 5 Is governance by shareholders necessary?: Employees’ quiet exit
• 6 The board of directors in stakeholder society
• 7 Corporate finance and its objectives
• 8 The bank-centered financial system in stakeholder capitalism
• 9 Is the mission statement important?
• 10 How should we evaluate Japanese firms?
• References
• Index