Shareholders vs. Stakeholders

One of the most basic principles of capitalism as practiced in the Anglophone countries is that those who own the equity  in a company, as represented by shares of the company’s stock, own the whole company. 

Ultimately, they control all of the decision making in the firm, as exercised in shareholder meetings and through the board of directors.  In theory, the board, as elected by the shareholders, chooses the executives.  For the moment, I’m going to assume that this theory holds true, though I’ll revisit it before I’m done.

Because they control the company, business decisions are made in the interests of shareholders.  In fact, the management of a corporation are required by law to do so.  Legally, they have no obligation to anyone else save to obey the law.  Shareholders can and do sue alleging breach of this fiduciary duty.

Obviously, though, there are other parties that have a stake in a company, its continued existence and its prosperity.  Among them are the firm’s employees, its vendors and its customers.  All of these benefit from the company’s success.  Employees earn their wages, vendors depend on it to generate their own revenues, and customers need it to provide goods or services.  Should the company contract, or even go bankrupt, all of these stakeholders suffer.

And yet, none of the stakeholders have any say in how the company is run, unless they are also shareholders.  It is taken as a given that their interests are completely subordinated to those of the shareholders in terms of corporate decision making.  To whatever extent they are dependent upon the success of the company, they are at the mercy of those making the decisions.

If we step back to first principles and set our assumptions aside, this seems kind of odd.  It certainly isn’t necessary that things be arranged this way.  In much of continental Europe, stakeholders are given influence over corporate decisions as a matter of law.  Despite proclamations of American exceptionalism, these arrangements don’t appear to have weakened the economies of these countries.  Performance is cyclical, with the different systems doing better under different conditions, but the long-term results are very similar.

The core of the problem is that ‘capital’ is defined very narrowly.  For the purposes of corporate control, it mostly consists of financing.  Money is capital.  The primary exception is what is known as ‘sweat equity,’ the share of the company that the founders of a company, typically, receive for their work at the start.  Their time and effort purchases for them the right to elect board members and the influence that comes with it.  Top executives often receive shares as a part of their compensation.  In some cases, the rest of the employees can get shares as well, but they are often held by an entity that prevents these owners from voting their shares.

It is telling that, in these instances, time and effort are treated as the capital of those who spend them.  Clearly, the principle that capital means money is not absolute.  Legally, however, that idea holds no force.  There are elaborate rules and regulations governing how those who contribute money to a company must be treated and how they may exert influence.  In fact, not only are the financial contributors protected, but anyone they sell their shares to receive largely the same protection.

The argument is that these contributors are making an investment.  They take a portion of their wealth and set it aside, foregoing spending it in the present and allowing someone else to use it in the hope that it will generate more wealth that they can access in the future.  It is this deferral of asset usage that entitles the investors to establish control over the company.

On the other hand, employees are considered to be completely compensated for their labor through the payment of wages.  People discussing the issue often don’t even recognize that a worker’s time is his capital, and thus carry an implicit assumption that he has no capital at stake.  This is a fallacy.  Laborers are committing capital to the company every bit as surely as a monetary investor.  Again, the business world implicitly acknowledges this by the acceptance that company founders should be compensated for more than the initial monetary investment they made, and that their time and effort deserves equity as well.

Taken from first principles, I find this argument unpersuasive.  Everyone involved with a corporation, inside or out, commits capital to its development.  Investors, in either equity or debt, stake claims to future earnings that they deem have a sufficiently high present value to make it worth deferring the payoff.  Customers pay money for its products.  Vendors set up sales relationships.  And the group that will be the focus of this essay, employees, commit time.  As explained elsewhere, time is their capital.

It is important to emphasize that, even setting corporate control aside, investors are being compensated for the money they give to the company.  They have generously said that they are willing to wait to take their compensation until some later date.  They have not-so-generously insisted that they get more money than they put in when they do take their payoff.  The generosity and non-generosity balance out, leaving them adequately compensated through purely monetary means.

It is also argued that equity investors have a right to corporate control because they are taking the risk that the company won’t make money.  If there is a bankruptcy, they stand last in line to get paid off.  Because of this risk, it is said, they need to have control over the corporation.  This would be persuasive, except that equity investors demand a higher rate of return than debt investors.  This is called the risk premium, and research has indicated that this premium more than adequately compensates equity investors for the risk.[1]  Even the risk taking is compensated through purely monetary means.  It could be argued that corporate control is necessary for the investors to see the risk premium, but there are plenty of reasons to be dubious of this assertion, and it raises the question as to why equity holders need to more than adequately compensate themselves.

If all parties receive monetary compensation for the capital they put into the company, it is unclear why certain forms of capital are entitled to a share of ownership and others are not.  If we understand that capital has a broader meaning than just a financial investment, this is more apparent.  However, despite many companies proclaiming, “Our number one asset is our people,” they don’t truly think of their people as a capitalized asset unless they’re engaged in some clever accounting.

The best argument for the current system is the purely practical one that it works.  This is not an argument to be dismissed out of hand, as systems that work are very hard to create.  It should be altered only with care.  However, the example of continental Europe shows that it is not the only system that works.  Putting all of the control of a company into the hands of shareholders is neither ethically necessary, nor the only form of corporate governance that works.  It should not be considered sacrosanct.

If that were the end of the story, then there would be no compelling reason to contemplate changing the Anglophile form of corporate governance.  It would be worth thinking about, and someone might assemble arguments as to why it should be changed, but there would be no pressing reason to demand it.

However, that is not the end of the story.  Another fallacy is the idea that other parties are fully compensated through payments that are effectively simultaneous with the capital that they contribute.  This is only true if the entity in question engages in a single transaction with the company and that concludes the relationship.  If the relationship consists of iterated transactions, then there is almost always going to be an element of deferred investment.

This is particularly obvious in the case of a vendor that makes its first sale to the company below cost, taking a loss in order to create a relationship in the hope of future sales that it can profit from.  This example is not one that provides any compelling argument for a share of corporate control, but it does demonstrate the way in which a party that is not typically considered an investor can be deferring its payoff in the same way that an equity holder does.  There is even the element of risk that there won’t be a payoff.  There is a difference of degree, including both the size of the investment and the expected time horizon of the payoff, but it’s not a difference of kind.

In the case of employees, the capital investment is more subtle, but also more profound.  A worker at any job becomes increasingly skilled over time.  Some of these skills would be useful at any job.  Some of them would be useful only at a job in the same industry.  Some skills are useful only at the company at which they are acquired.  The improvement of skills is generally recognized by promotions and pay increases.  However, the more restricted the potential uses of a skill are, the more their acquisition constitutes an investment with an expected future payoff, namely continued value to the company.

If the firm goes bankrupt, or lays off the employee, the future value of these skills is either reduced or eliminated.  The investment loses value.  The worker may have received sufficient dividends, in the form of increased wages over the previous years, thanks to the skills, to have made the investment profitable, but the capital value of their acquisition is degraded.  In this way, the investment in skills is no different than an equity investment, which can also receive dividends but see the asset value go to zero.

There is more to it than that.  It is rarely explicit, and usually hard to identify in any individual case at all, but age discrimination is pervasive in hiring in the United States.  This becomes apparent when one looks at the unemployment data at the Bureau of Labor Statistics.  People in their 40s and 50s are less likely to be unemployed than those in their 20s, but for those that are unemployed, they remain that way for a much longer period of time.  It is so bad that a significant number of 50-year olds that lose their job will never have meaningful employment again.  The world will simply discard them, no matter how much value they could still create.

Without debating whether this is an appropriate attitude for businesses to take, what it means is that every day spent at a company is not only a sale of time in the present, but also an investment in the future.  Every year that ticks by makes it less likely that an employee will be able to find a job working for some other entity.  He becomes more dependent upon his future with his current employer.  This is an investment in every way like that made by an equity holder, save for the nature of the capital invested. 

The argument that corporate control should be in the hands of financial investors that rises above the level of, “Just because,” rests upon the denial that time is a form of capital that can be invested.  Given that the behavior of actual businesses in practice makes it clear that there is a consensus that time can be invested under some circumstances, there doesn’t seem to be a higher level for the claim to rise to.

This problem has manifested itself in Ontario, CA.[2]  For decades, BMW has had a parts warehouse there or in Carson.  Its workforce has been represented by the Teamsters for 40 years.  When the time came to negotiate a new contract this June, the company informed the union reps that they were closing the warehouse as of August 31, the date when the current contract expires.  BMW has decided to use an outside company  rather than the facility that has long been considered a model of efficiency.  The company claims that it wants to concentrate on its core competency, but it is widely suspected that it also is motivated by a chance to save money through a vendor that will pay far less than the $25/hour that the current employees average.

On the one hand, this is an example of how management and employees often aren’t on the same team.  On the other, it is an example of employees’ investment in their future employment evaporating.  These employees had no say in the decision to close the plant.  They were not even given a chance to negotiate and accept lower pay in their next contract.  We have extensive laws to protect the investment that shareholders have made in BMW.  There are none to protect the investment that the employees made.  It can be, and in this case has been, destroyed at the discretion of other parties.  Ironically, this would not be the case in BMW’s home country of Germany, and the move likely would never have even been proposed.

The company’s switch to a non-unionized supplier will save it money, at least in the short-term.  It will also destroy the livelihoods of the 71 employees who will be out of a job on September 1.  Those who find new employment will almost certainly do so at a fraction of the income they previously received.  Tim Kitchen is 53 years old and has worked for BMW for 32 years.  There is a significant chance that he will never have serious employment again.  He won’t have a way to pay for his daughter’s college education.  Miguel Carpinteyro, aged 42 and with 14 years of seniority, just had a pool built as his house.  This wasn’t a luxury purchase; he has two autistic children and the pool was recommended as therapy for them.  Now he’s likely to lose the house and pool, and struggle to pay for the therapy his children need.

This is not meant as a sob story, though it can certainly become one.  It is meant to show that workers, too, make an investment in the company they work for and the destruction of that investment is every bit as serious as it is for equity holders who see their stock go to zero.  They should have the ability to influence the future of their investment every bit as much as equity holders should.  The distinction between shareholders and stakeholders is one example of the extraordinary privilege that some types of capital have in our system.

And how about those corporate executives I said I would get back to?  Not only do they receive very high wages, but the overwhelming proportion of them also receive an equity stake in the company, often in the form of stock options.  Their investment in the company is not only protected by their position of authority for decision making, but also in that they have a say in retaining themselves as executives.  If that’s not enough protection, they usually have generous severance packages built into their contracts in order to cushion the blow of losing their investment as an employee, just in case they failed to save enough of their salaries to live on.

It isn’t that the corporate world doesn’t implicitly recognize that stakeholders have an investment in their companies.  They’re just very stingy about which stakeholders it deems worthy of protection.

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[1]More recent research indicates that the risk premium may be declining, but it is not yet possible to say that it has decreased to the point that it no longer adequately compensates equity investors for the risk.

[2] See Michael Hiltzik’s column in a July 3, 2011 business section of the Los Angeles Times.