Crisis, Commitment and the Corporation

Colin MAYER

Today's presentation will discuss one of the most remarkable institutions in the world— the corporation. Corporations affect all of our lives greatly. They are responsible for housing, clothing, and feeding us. They also invest a substantial proportion of our wealth. Corporations are a source of remarkable prosperity and the cause of the growth of nations around the world. However, although it can be said that corporations have achieved all of this, it could also be said that they have been responsible for great poverty, deprivation, and environmental degradation. Over the last few years alone, we have experienced economic bubbles burst in the United States, the corporate governance scandals of Enron and WorldCom, the 2008 financial crisis, libel scandals, and the environmental disasters of the Gulf of Mexico and Fukushima. Each of these has been regarded as having their own particular causes, such as bad information, governance standards, regulation, taxation, and management. It is said that each of these needs its own solutions such as more transparency, better governance, increased regulation, improved taxation, and superior management. Today's presentation will argue the case that all of these problems do not have their own individual causes and do not require specific solutions. Rather, it will be argued that there is a common factor which needs to be dealt with regarding these problems, which is the corporation.

The current concept of the corporation is as what is taught in economics departments of business schools, which is that of a production line. There is an image of inputs of materials and labor, which are combined together with capital and land to produce outputs. There are views that the corporation is a social construct for reducing the transaction cost in the market as well as within the firm. There are legal views of the corporation which see it as a nexus of contracts bringing together different parties to the firm. Above all, the corporation is viewed as acting in the interests of one particular group, to whom the directors of the firm are responsible. This group consists of the shareholders, and the objective of the firm is essentially concerned with maximizing the value of the capital of and returns to those shareholders. The regulation of corporations is pursued when they tend to fail to act in the broader interests of society, and, if necessary, they are put into public ownership. This view is widely accepted as the appropriate view of the modern economy, and is the basis of national and international policies around the world. However, it must be argued that this is a fundamentally misconceived notion.

The failure of the widely-accepted view of the corporation lies in the understanding of what is a corporation and what it should be doing. The corporation neither simply carries out a production function nor represents a nexus of contracts. It also does not exist primarily to further the interests of shareholders. The corporation exists to make and produce goods and services for the benefit of its customers and for communities in general by combining together the different parties of the firm, such as employees and suppliers, and representing their interests in a balanced manner. The ability to provide commitment to and exercise control over these parties allows corporations to function effectively. Corporations are powerful instruments in this as they represent distinct entities with tremendous capabilities. It is essential to find a way to bring corporations back under control so that they truly represent the interests of society in order to move forward.

The current situation related to corporations didn't always exist. They were originally established by the state or by royal charter and were designed to further trade and discovery around the world, build canals and railways, and engage in activities which had a real public purpose. Such corporations were then allowed to incorporate freely and were essentially owned and controlled by individual family owners, who had a long-term view as to what was in their interests. However, those family-owned corporations had problems with financing their activities so they issued shares. As shares continued to be issued, family ownership declined and was replaced with more widely-dispersed share ownership, which led to a problem. There were no shareholders who had an interest in ensuring that the company was well run. This problem was solved through the emergence of markets for corporate control, incentives for management who acted in the interests of shareholders, and active institutional engagement in companies. This served to make the main objective of companies the maximization of shareholder value, and extensive shareholder control of corporations followed.

Alongside developments in the ownership and control of companies was a view that the fundamental problem facing companies was how to align the interests of management with that of shareholders. Therefore, most discussions and policy recommendations related to firms were concerned with addressing this agency problem. Legislation around the world, such as the Sarbanes-Oxley Act, Dodd-Frank Act, the Cadbury Code, and European Commission directives, were all aimed toward solving this issue. It could be said that this problem has been solved as interests have been aligned, and there has been much more active governance by shareholders. This is no longer the fundamental problem afflicting corporations.

Fraud is rampant in corporations—not in a literal sense but more subtly. As an illustration, the problem that afflicted banks during the recent financial crisis was due to managers acting too much in the interests of shareholders. Shareholders themselves pursued activities associated purely with maximizing returns, to the detriment of other participants in banks. High-risk activities reward shareholders financially if they go well and negatively impact creditors and bond-holders if they don't. Therefore, shareholder influence had a significant impact on the high-risk activities of banks. This highlights a problem between shareholders and creditors as their interests are fundamentally misaligned. Strengthening corporate governance potentially worsens this problem as it allows high-risk behavior in corporations at the expense of creditors.

Creditors are not the only party which has interests divergent from those of shareholders. Employees of corporations have an interest in the survival of their companies, and high-risk actions of shareholders can also be to their expense. Other parties such as suppliers and communities are also connected to this issue. It has been mentioned before that it is natural for companies to support the interests of such parties in order to protect their reputation. However, it could easily be argued that this is not the case. On June 27, 2012, an announcement was made at the London Stock Exchange that Barclays Bank was fined more than 200 million pounds sterling by U.S. and UK regulatory authorities for engaging in a libel scandal. Over the four hours following this announcement, its share price actually rose. This reaction of share prices going up after companies engage in misdemeanors has been widely observed. If the corporation benefits its shareholders by engaging in activities that come at the expense of the public, it follows logically that the stock market should react positively. It is only in situations where companies are seen to have harmed their own customers and investors that share prices react negatively. As such, issues related to the reputation of companies are of limited value in solving this problem.

A conflict of interest in firms has also been observed among shareholder groups themselves. Eighty years ago, the average shareholding period in companies was seven years; 40 years ago, this number was three years. Today, this period has shrunk to only a few months. The main reason for this rapid decline is the emergence of high-frequency traders, who tend to hold shares for a very short period of time. Increasingly, ownership of companies is being held by investors with a very short-term outlook, whose interests may benefit a company in the short-term but not in the long-term. Short-term systems allow current investors to enjoy high returns against the small possibility of suffering large losses in the future. Essentially, this means that the future generations are bearing the costs and risks associated with the short-term gains that the current generations are earning. Therefore, another problem of the modern corporation is what will happen to the future generations if current issues are not solved.

In the early part of the 20th century, Japan enjoyed a thriving stock market with a large number of individual investors, dispersed ownership, and companies which raised a lot of financing from stock markets. Those active stock markets were supported by a number of parties, and the features which it thereby gave rise to in terms of dispersed ownership were similar in many respects to what could be observed in the United Kingdom and the United States. However, that structure changed dramatically during the post-Second World War period in response to the break-up of zaibatsu and through the introduction and implementation of regulations and investor protection in Japan. Such regulations were designed to encourage individual investors to invest in Japanese companies. Eventually the stock market collapsed, and banks had to take ownership of Japanese corporations. In the 1960s, securities companies engaged in fraud and various forms of market manipulation, which led to the banks buying up equity. By the 1970s, the characteristics of banks and other institutions owning Japanese corporations had emerged. At the end of the 1980s, the financial markets were deregulated and the control that banks were able to exert over the corporate sector was undermined by the ability of companies to enter the bond markets. This in turn led to the collapse of the economic bubble and the banking crisis that subsequently emerged. Since then, there has been a shift toward foreign, institutional, and individual ownership in Japan. However, attempts from outside investors to exercise control are generally unsuccessful in Japanese corporations. The current Japanese system is more or less halfway between the traditional Japanese model and the current Anglo-American model.

Although the system related to corporations in Japan is different from that of the United States and the United Kingdom, there are problems of a corresponding nature which arise. The problem associated with bank ownership of corporations is exactly the opposite in Japan in comparison. In the Anglo-American system, the problem is that the shareholders tend to exploit the creditors. In Japan, the problem associated with bank ownership of corporations is that banks tend to pursue their own interests in promoting bank lending and investment while also acting as shareholders. There are equivalent problems which exist in terms of the ownership and governance of corporations in different countries. It is crucial to recognize that corporations lie at the heart of the problem in modern economies, and to find suitable solutions.

The re-establishment of trust in corporations is an extremely significant goal which should represent the basic objective of reform in corporations. In order to achieve this, it is crucial to ensure that those who have control of the corporation are dedicated to investing for the long-term. Short-term investors play a very important role in providing capital and helping to set prices in markets. However, it is wholly inappropriate that the running of companies should be in the hands of those with short-term views on the objectives and benefits of the corporation. This can be readily achieved by conferring the voting rights in corporations on long-term shareholders. There should be registered shares held by shareholders who will hold them for specific and particular periods of time. Those shareholders should have voting rights in companies, with short-term shareholders having far fewer or no voting rights.

A second important feature for the positive reform of corporations is that they should expound the values which they uphold clearly. Corporations in Japan have essentially had objectives which are not necessarily purely those of shareholders. A survey of companies in France, Germany, the United Kingdom, the United States, and Japan reported that the vast majority of middle management in the United Kingdom and the United States perceived the objectives of their corporation as being essentially concerned with only shareholder interests. In the case of Japanese middle management, only 3% of the respondents said that they thought the objective of the company was to pursue only shareholder interests. When asked what would likely happen if their company got into difficulty, 90% of the Anglo-American management said that employment would probably be reduced, rather than dividends cut. Only 3% of Japanese respondents stated that their company would cut employment, with most believing that it would be more likely for dividends to be cut. It seems that companies can pursue interests beyond those of shareholders perfectly well, while still being shareholder-oriented companies. Corporations must clearly expound their values and in whose interests they are acting. They also must be able to demonstrate credibly that they will be upholding those values through boards of trustees.

Some of the most successful corporations in the world illustrate how effective such measures can be. IKEA, BOSCH, Bertelsmann, Carlsberg, and Tata all share a common characteristic—they are owned by industrial foundations, which are essentially charities. Those foundations hold for the long term, and the primary role that the boards of the foundations perform is not to engage in active management, but to ensure that the corporation upholds its stated principles.

The corporate tax system can also be used as a way of aligning the interests of corporations with the public interest. Corporate taxation is primarily used now as a way of raising revenue for governments. In fact, this tax system could be used to ensure that companies take account of the broader social aspects of their activities. In other words, companies which represent the public interest better could essentially be recipients of corporate subsidies rather than payers of corporate taxes, and those who exploit the public interest could be those which primarily pay corporate taxes. Regulations are also critical in aligning the interests of firms with the public interest, and they are required to ensure that corporations do not act against the public interest through breaking laws associated with bribery, corruption, and fraud, along with upholding environmental rules. It is important to reach a stage where corporations are able to regulate themselves and uphold their own principles. If this can be achieved, corporations will become vehicles for protecting both the future and current generations.

In summary, there are several issues which should be acted on in order to address the problems of corporations. There should be tougher regulations when corporations engage in violations of the law. There should be stronger regulations to deal with systemic failures, and banks should be allowed to hold greater amounts of capital to address such problems. Elsewhere, there should be less intrusive regulations. Regulations should not be used as the mechanism for imposing the moral authority of corporations, instead, companies should be responsible for their own conduct. Corporations should be encouraged to do so by having long-term owners in control, with clearly stated values as to whose interests the corporation is acting on, and independent boards should be responsible for ensuring those values. Business education should also be used to ensure that future business leaders are aware of their responsibilities beyond those of maximizing short-term shareholder interests. Such principles should be adopted by governments around the world, and these practices should be applied by corporations. Corporations which were founded on strong moral and ethical principles over time have been taken over by shareholders with no interest other than economic return to themselves. Ultimately, we need to reformulate our view of the corporation in order to appreciate that it is essentially an organization that needs a moral basis behind it. In the end, it is the moral corporations that are also the most commercially and economically successful in the world.

MIYAJIMA Hideaki

The bottom line of today's presentation was the introduction of Professor Mayer's new views on firms. The conventional view of the firm is that of a production line and a network of contracts. It was suggested that the role of shareholders in firms should be reformed, especially considering issues related to morality and trust. From this perspective, what is interesting in understanding current firms is that normally we see the separation of ownership and control as a major source of problems, i.e. agency problems. However, what was stressed today is that it is actually a good base for the commitment of stakeholders to firms. As for the current situation, it was emphasized that excessive shareholder governance is an important issue which must be resolved. It was also suggested that values in corporations should be very clearly stated and upheld, and that measures should be put in place to promote long-term shareholder control. Finally, Professor Mayer suggested that boards of trustees be established, with their role of upholding company values and balancing the interests of all parties associated with the corporation.

From the perspective of Japanese corporations, the danger of overemphasis of shareholder interests over that of other parties plays a less important role than it does in the United States and the United Kingdom. In fact, it could be argued that the problem in Japanese companies is the lack of risk taking. Balancing the multiple stakeholder interests in Japanese corporations is something worth pursuing. Regarding mechanisms for giving more voting rights to long-term shareholders in corporations, long-term shareholders exist in high numbers in Japan, although they don't tend to play an active role in corporate governance. Finding a way to increase the activity of corporate governance of long-term shareholders in Japan is another issue which must be addressed. Establishing independent boards of trustees responsible for upholding company values was another subject discussed in today's presentation. In Japan, how to go about designing such boards is an issue currently being discussed, including details on how stakeholder and employee interests could be represented, and what kinds of people would be appropriate candidates for such boards.

Colin MAYER

Regarding the different relationship between creditors and shareholders, it is true that Japan seems to be in the opposite situation to that of the United States and the United Kingdom. In Japan, it seems that creditors have exercised too much control, leading to investments which are overly conservative. In terms of alternatives if registered shareholdings are not feasible, the critical element is to allow some shareholders more voting rights than others, rather than the registration process itself. Registered shares would seem to be the most natural way of accomplishing this, but is not a necessary characteristic in such a proposal. Boards of trustees being used to uphold the interests of various parties directly may be a possibility. However, for the most part, it may be best that election to the board is done by shareholders. In selecting appropriate candidates, it would be desirable to have those who are trustworthy and have strong values, integrity, and honesty above those with business skills.

Q1: Regarding the long-term ownership structure, it was mentioned that it is important to give more control in corporations to long-term investors. However, current ex-post long-term investors are not necessarily future long-term investors. How would you go about separating ex-post and ex-ante long-term investors?
Second, under the moral system of promoting the voting rights of long-term investors, it could be said that rival companies could simply remain the same, allowing them to gather more capital in the market over the short term. How could a company which emphasizes long-term voting rights compete with this?

Colin MAYER
It is important to highlight that more control of ownership in corporations should be given to shareholders who are committed to the long term in the future. Organizations such as pension funds have an interest in doing this as their liabilities are over the long term. If there were registered shares, particular investors such as pension funds could indicate their willingness to hold for the long term over specific periods of time. Regarding moral corporations with emphasis on long-term investment competing with those with emphasis on short-term investment, the moral corporation will be the more commercially successful of the two. The reason for this is due to the benefits of aligning the different interests of parties with the corporation's needs. Successful companies mentioned in today's presentation manage to limit the control by short-term shareholders while still being very profitable.

Q2: Japanese companies currently tend to have enormous cash holdings, with very little investment being made. It seems that more capital is not necessary. How important is the role of outside capital providers to corporate governance, and what do you see as the future of Japanese corporate governance?

Colin MAYER
First, it is important to emphasize that outside investors often do play very important roles in governance. They are frequently able to determine the conditions in which companies can raise money from the stock markets. The most effective corporate governance is not exercised through institutional activism, but done so when companies attempt to raise funding through the stock markets and investors impose conditions on them. In the case of Japan, it is clear that corporations have not been adequately taking account of the interests of outside investors in terms of adequate distribution of dividends to those shareholders. Outside investors are and should be very important in Japan, and the fact that they can't exert any control through financing illustrates this problem.

Q3: There are several opinions and ideas about how policy should be changed in Japanese corporations. What kind of mechanism for establishing general long-term objectives would be useful to implement?

Colin MAYER
Diversity of corporate policy is a very important issue. One attractive feature of corporations over a single government is that they can allow for very different values and principles. Furthermore, suppose that one issue, such as the role of women in the workplace, becomes a matter of national interest. In such case, the tax system could be used to encourage companies to adhere to such policy.

Q4: Do you have any suggestions as to how corporate values should be defined and measured?

Colin MAYER
Work is currently being undertaken in measuring company performance in more general terms. The Natural Capital Committee in the United Kingdom is concerned with how to measure the contribution of the country and companies to the promotion of natural capital. In fact, it is possible to create measurable values which are more reliable and informative than those of shareholder returns. This is because shareholder return values are based on the market values of companies and projections on dividends into the indefinite future. Measuring the cost of sustaining forests or keeping rivers clean is much more tangible and accurate than measuring shareholder value. Being able to translate corporate value into measurable content is critical in solving problems related to corporations.