1.4 Corporate Governance
GovernanceThe way an organization is formed, structured, and controlled. It refers to the structure of authority within an organization. refers to the way an organization is formed, structured, and controlled. It refers to the structure of authority within the organization. In this section, we first compare and contrast the three basic forms of business organization: sole proprietorshipA type of business entity owned and run by one person., partnershipA type of business entity owned and run by two or more persons who have agreed to work together., and corporationsA type of business entity that is independent of its owners, the shareholders. This entity may enter into contracts in their own name.. Then, we focus on corporations in more detail. We describe the legal structure of a corporation. We discuss the legal duty of the board of directors and the goals of management. We conclude with a discussion of governance problems, particularly the principal–agent problemThe problems and costs that occur when an agent does not maximize the utility of the principal..
Forms of Business Organizations
Table 1.4 lists the advantages and disadvantages of the three forms of business organizations: sole proprietorships, partnerships, and corporations.
Table 1.4 Forms of Business Organizations: Advantages and Disadvantages
|
Business Structure |
Definition | Advantages | Disadvantages |
|---|---|---|---|
| Sole proprietorship | A type of business entity owned and run by one person. |
|
|
| Partnership | A type of business entity owned and run by two or more persons who have agreed to work together. |
|
|
| Corporation | A type of business entity independent of its owners, the shareholders; corporations may enter into contracts in their own name. |
|
|
Figure 1.15 shows the breakdown of establishments and annual sales by organizational form in the United States. Although the majority of establishments are structured as sole proprietorships (61%), they only account for 2% of all sales. In contrast, corporations account for 91% of all sales. Given this statistic, you will not be surprised to know that we focus our attention on corporations (although many of the tools developed in this book are applicable to proprietorships and partnerships as well).
Figure 1.15 Number of Firms and Sales by Business Structure in the United States
Sources: Data from www.Bizstats.com; FlatWorld
Corporations and Governance
In this section, we first review the legal structure of corporations. Then, we look at the legal duty of the board of directors and how that relates to the goals of financial management. Most states require directors to maximize shareholder welfare. When directors (and managers) maximize their own interests we call it a ‘principal–agent’ problem. Finally, we’ll describe a competing conception of the duty of directors called stakeholder capitalism, which has given rise to the ESG phenomenon.
The Legal Structure of the Corporation
Figure 1.16 shows an organizational chart for a corporation. At the top are shareholders, who are the owners of the company. The owners’ control of the corporation is exercised through their right to vote for members of the board of directors. The board of directors hires the senior management and sets their compensation. The board also reviews and votes on all major initiatives.
Figure 1.16 Organizational Structure as a Corporation
Source: FlatWorld
The Duty of the Board and the Goals of Financial Management
In this textbook, we make recommendations about best financial practices. To recommend a best practice, we have to know the goal of the decision-maker (i.e., the board and the company’s managers). What objective function should managers maximize? In a sole proprietorship, the manager maximizes the interests of the owner because the two individuals are one. In a corporation, ownership and control are separate, so the duty of the manager is less clear.
In the United States, approximately 60 percent of Fortune 500 companies are organized under Delaware corporate law. Delaware courts have established that directors have a fiduciary duty A duty of care, loyalty, and good faith. to make decisions in the best interests of shareholders. This economic philosophy is called shareholder capitalismThe economic system that results when corporations maximize the wealth of their shareholders.. In one of his decisions, Delaware Supreme Court Chief Justice Leo E. Strine, Jr. explains the duty of directors under shareholder capitalism:
Economists have long understood that when companies maximize the wealth of owners, then social welfare is also maximized. Adam Smith observed this in 1776:
Every individual necessarily labors to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it . . . he intends only his own gain, and he is in this . . . led by an invisible hand to promote an end which was no part of his intention.
The invisible hand is the price system. In this passage, Smith argues that the public interest is maximized under shareholder capitalism--when business owners maximize their own profits.
A competing view of the duty of directors (and managers) is that they have a responsibility to a broader constituency which includes: customers, employees, lenders, suppliers, the environment, and society at large. This view is called stakeholder capitalism A system in which corporations are oriented to serve the interests of all their stakeholders, including customers, suppliers, employees, shareholders, the environment, and local communities. or corporate social responsibility (CSR).
Until 2004, Canadian corporate law adhered to the shareholder capitalism view. This changed dramatically following two Supreme Court of Canada (SCC) decisions: Peoples v. Wise in 2004 and BCE v. Debenture holders in 2008. Prior to those decisions, Section 122(1)(a) of the Canadian Business Corporation Act (CBCA) stated that directors were to exercise their powers with a view to the best interests of the corporation. The corporation was understood to mean the shareholders. In their BCE decision, the SCC argued that the corporation does not mean any particular stakeholder group and that no group has primacy.
Thus, since the 2008 BCE decision, the courts in Canada have embraced stakeholder capitalism. Perhaps surprisingly, this does not mean that corporate boards have embraced the stakeholder view. Most boards try to maximize shareholder interests, because board members are still elected by shareholders. Until shareholder control of the board changes, we should expect companies to act as if shareholder capitalism is the prevailing orthodoxy in Canada.
Critiques of Stakeholder Capitalism
Milton Friedman, the economist, penned a famous critique of stakeholder capitalism (CSR) in a 1970 New York Times op-ed titled ‘The Social Responsibility of Business Is to Increase Its Profits.’ Friedman criticized businesspeople who:
. . . declaim that business is not concerned ‘merely’ with profit but also with promoting desirable “social” ends; that business has a ‘social conscience’ and take seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers. In fact, they are . . . preaching pure and unadulterated socialism.
Freidman criticized CSR as an example of the principal–agent problem.
When principals (stockholders) cannot monitor agents (managers) easily, then managers have the opportunity to use corporate resources in ways that benefit themselves but may not benefit shareholders. Examples include perquisite consumption like corporate jets and Manhattan headquarters but also the expenditure of corporate resources on managers’ preferred social causes like climate change, trans activism or anti-racism. This conflict of interest is called a principal-agent problem. To solve the principal–agent problem, shareholders need to spend resources to align managers’ interests with their own. For example, by compensating directors with stock options. The loss of shareholder wealth associated with managerial waste and the cost of resources used to monitor agents’ behavior and align incentives are called agency costs A cost associated with principal–agent problems. The loss of the principal's wealth associated with the agent's waste and the cost of resources used to monitor agents' behavior and align incentives are called agency costs. .
Explain It: Principal–Agent Problems
One of the most popular modern proponents of stakeholder capitalism is Klaus Schwab, Executive Chairman of the World Economic Forum and author of ‘Stakeholder Capitalism: A Global Economy that Works for Progress, People and Planet.’ Schwab’s vision for stakeholder capitalism is an economy where businesses, government and civic institutions work hand-in-hand—what he calls ‘public-private’ cooperation.
Vivek Ramaswamy criticizes stakeholder capitalism as undemocratic. He argues that businesses who advance social causes using corporate resources influence the political discourse with other people’s money. ‘It allows them [businesspeople] to exercise quasi-political power without having to go through the hassle of getting elected. Yet that hassle is part and parcel of democracy itself.’
ESG
The most recent manifestation of stakeholder capitalism is ESG Stands for environment, social, and governance. . ESG stands for environment, social, and governance. ESG works like a corporate social credit system, which investment managers use to attract socially conscious investors. The marketing pitch is as follows: investment managers advertise that they only invest in good (high ESG scoring) companies and that they will use their capital to influence corporate decision-making in a socially just direction. This influence is called ‘capital force.’ The two main tools of capital force are: (1) activist voting for corporate director; and (2) divestment of ‘bad’ companies. Of course, the effectiveness of capital force and the possibly deleterious effects on risk and return are unspecified. Investors take a blind leap, but one that appears very popular judging by flows of money into ESG funds.
The ESG social credit score is calculated by rating agencies who assess companies on three dimensions: (1) green house gas emissions; (2) their embrace of diversity, inclusivity, and equity; and (3) the quality of their governance. The ratings agencies (MSCI, Refinitiv, S&P) use different scoring systems which are all proprietary. The end result is an ESG score for each company.
Academics have observed that the ESG scores are not consistent across agencies, which makes them an unreliable measure. Elon Musk called ESG ratings a ‘scam’ when the S&P 500 ESG Index dropped Tesla from its portfolio but retained its holding in Exxon. Because of complaints, in 2022 the Securities and Exchange Commission created a Climate and ESG Task Force to investigate ESG-related misconduct.
Conclusion
Despite the ongoing debate between proponents of shareholder and stakeholder capitalism, throughout this book we will assume that directors and managers make decisions in the best interests of shareholders. This assumption is especially important in Chapter 9 “Capital Budgeting: Introduction and Techniques” when we study what metrics managers should use to evaluate new projects.