The Ownership Disconnect – Managers, Shareholders, Risk and Markets

Or a case of: Absent owners,  managers that act as if they own and get paid as if they take all the risks

Since the banking crisis that became a sovereign debt crisis, the world has begun to focus on the huge salaries and bonuses that are paid to bankers and top business people. In the last week, Barclays Bank announced that over 400 of their staff earned over £1 million in the last financial year.

Whereas those who place their financial lives on the line by building their own businesses and then, if successful, reap the financial rewards – but, if not successful, may lose everything – remain in high esteem amongst most people, those that risk no financial penalties whatsoever (but take massive salaries) have slipped further and further down in the public’s esteem quotient.

Senior managers and directors of major companies (including banks) and sales staff that take home huge bonuses (especially in banking and finance) are no longer lauded for any value they bring amidst a view that their rewards are far too high bearing in mind the lack of risk that they have. This has resulted in the EU plans to limit the bonus payments to bankers – an extraordinary intervention in the marketplace.

Does the marketplace work?

Stock markets are deemed to be the best place to see demand and supply at work. There is more data collected on stock prices than anything else and it goes back hundreds of years. Constant pressure on transparency and liquidity means that markets like the US (DOW, S&P, Nasdaq) and the London Stock Exchange (and others of similar size and liquidity) ensure that supply and demand usually results in a price that means something.

While this has changed markedly with the intervention of computer-driven buying and selling as well as the fact that around 70% of stock is owned by institutions, nevertheless stock markets appear to be mainly market driven. That never means the price is “right” – markets provide a price on any day that may be driven by a myriad of reasons. However, the market price is the price and buyers and sellers are able to take legitimate decisions whether to buy or sell.

Secondary markets

The owners of stocks and shares have, in the vast majority of cases, bought those stocks and shares in a secondary market – long after the IPO. While the majority of today’s owners of Facebook may be IPO buyers, this is only because the company had its IPO just months ago. For the rest of the publicly traded corporate sector, buying shares has little to do with the company involved.

Ownership of a share means potential increase in capital value and dividends growth – and some ownership rights which are rarely used by the individual buyer (although Martin Sorrell is facing some pressure from recently voluble fund holders). Shareholders are primarily interested in the value of the stock – almost unrelated to the company.

Robert Beckman, a well-known business writer from the 1990’s, estimated that 70% of a share’s value related to the way the market was going, 20% related to the industry and only 10% related to the individual stock. If true, this means that ownership of shares in the quoted sector is almost unrelated to the individual stock and owner responsibilities are negligible and rarely used.

In addition, the development of the joint stock company limits the risk to just the loss of the investment and no more (unless buying stocks through leveraged schemes or option trading).

Ownership means almost nothing these days when that ownership is in a publicly traded company.

Staff acting as owners

Lack of ownership in publicly traded companies (the understandable move away from the 19th Century where owners were managers), means that senior managers now act as owners. While it is absolutely true that managers spend considerable time talking to representatives of shareholders (pension funds and similar) and to others who write on their stocks (such as journalists), this is to keep the price up in the market relative to other stocks in the secondary market. It is part of the process of market transparency. Today, that is the main connection between management and owners (at least in terms of the value placed on the stock).

The Board  (with non-execs here to represent the shareholders) carries out primarily a governance role and has, usually, a compensation committee. Their job is to see that senior staff are paid a salary commensurate with the market or whatever and to secure senior staff in their jobs. This crucial role has, of course, been shown to be spurious in recent years.

The banking crisis has shown that there is no such thing as market rates for top staff in major corporations. Has it been just a way of jockeying for position that seeks to provide pay at the highest levels possible? CEO’s claim that they need to be paid international salaries to stay in their UK jobs no matter how poorly their companies’ share price performs.

Recent comments from those involved in the industry show how few CEO’s move abroad or from abroad to the UK. This basic tenet is mistaken, let alone the requirement to pay huge commissions to banking staff when their risk – like those of CEO’s – is no more than to keep their basic pay (already substantial) or in the worst case lose their job. This is completely unlike the entrepreneur, who has both management and ownership, and the heaviest of financial risks – the potential to lose his / her financial assets as well as their job. Both get potentially great rewards, but their risks are completely different.

Market rates of pay are notoriously difficult to derive. Where there is a vast statistical database, then it is possible – although here the markets are driven in different directions by groups of people getting together in unions to drive up market rates (and other forms of benefits).

The shareholder / manager dilemma

 

This can be stated for modern corporate life (in publicly traded companies) as:

Owners that stand back too far leaving managers that act as if they own companies and get paid as if they take all the risks

The issue is important for many reasons. We now have huge and dominant multinational corporations. We have shareholders that seek high and constant returns but have no affinity to the companies they “own”. We have managers that are (too?) highly paid and have wrestled a much higher share of the companies’ income to themselves than ever could have been envisaged and (in the UK and the USA at least) with over-dominant banking and financial centres which have tended to suck the life out of the entrepreneurial sectors rather than giving it life.

Can Shareholder Activism be Re-ignited?

As the West sinks dismally into austerity and behind the newly developing economies of China and India, where corporate ownership is complicated by government (intervention or direct ownership), we need a rebalancing away not just from banking and finance to areas of real value creation. We also need incentives for owners to own and managers to understand and accept real risk before they can access the type of returns that real entrepreneurs can access.

This will (if it is possible) drive any massive returns to the holders of real risk – those who can lose everything or gain massively. This is not the lot of managers – whose risk profile is slanted to the positive and whose manipulative skills are far greater than the quasi-shareowners buying their ownership in secondary marketplace.

Entrepreneurship is at the heart of business and growth of any economy. But, it is stifled by the rise of the manager in publicly traded companies where that rise absorbs far too much of the value created.

Shareholders are slow to act as they are, in the main, too far from the action, unknowing or a manager themselves – as in pension funds.

Now, the UK coalition government will be giving shareholders the right in annual general meetings to reject senior Directors’ pay proposals. The EU is considering the same thing. So, the pendulum is swinging in the direction of shareholder activism after many years of drift and decay. On both sides of the Atlantic, it is necessary for shareholders – who actually, in law, own companies, to assert themselves in pay and other issues. Economies in the West are dividing between those who are in control of an unrealistic share of corporate income (and in 2011, FTSE Directors pay rose 49% while average pay in the UK rose just 2%) and others. The others are shareholders and other employees.

A true market can only operate where monopolies fear to exist. It is apparent that quoted company directors have been able to set their salaries within a close market situation. In a long recession that we have seen in the West since 2008, it would be remarkable for there not to be a kick-back against the ability of one sector of society to benefit so much. Asking for constraint is insufficient. Markets have to be enabled and the recent moves to encourage shareholders to be more active and to give some powers that actually work are in the right direction.

Now it is up to the shareholders (basically, the senior staff of fund-holders like pension funds) to bare their teeth – like they are doing at WPP – and show that just because they go to the same clubs and come from the same schools, shareholders can be properly represented and the market for top directors’ pay can be made efficient.

A Proposal or Three

With stocks bought in a secondary market where ultimate owners have little or no real understanding of the business or ownership responsibilities, it seems reasonable to require large owners of shares to take their responsibilities more seriously – how should secondary market shareholder activism become real? Some suggestions:

Proposal 1: all owners of more than 1% of shares of any traded company should be required to nominate a non-executive director or actively support the nomination of one proposed by another such organization.

Proposal 2: such organizations, who normally buy shares on behalf of others (pension funds, hedge funds or similar) should ask their own investors (mainly those who put their savings into those companies – not just their own shareholders) to vote on their proposals.

Proposal 3: all such organizations have to register as “major shareholders” when they accrue over 1% of stock in a company and the FSA / Stock Exchanges should monitor the job they individually do to actively monitor companies – in the same way that organizations monitor MP’s voting.

All the above relies on making this easy – e.g. online only voting within pension funds and similar (i.e. no computer access, no vote) but, in an age of digitization and where companies and owners are so disconnected, secondary markets need to become activated.

 

The Corporate Paradox

 Chimeric Corporations

This week, Danny Alexander has announced that the UK government will not allow companies that have proposed tax schemes that have been found to be unlawful to bid for government contracts.

The G20 announces that governments across the world will work together to ensure that companies pay the proper rate of tax in the countries in which they do business.

Why now, after over 500 years of the joint stock / limited liability company are governments beginning to attack the privileges of the multinational – companies that operate across borders but ask us to believe that what they do is for our good as consumers and for the good of their shareholders?

Paradox: any person, thing, or situation exhibiting an apparently contradictory nature.”

Company: “An entity, usually a business, created by a legislative act or by individuals who have agreed upon and filed articles of incorporation with the state government. Ownership in the corporation is typically represented by shares of stock. Furthermore, a corporation is legally recognized as an artificial person whose existence is separate and distinct from that of its shareholders who are not personally responsible for the corporation’s acts and debts. As an artificial person, a corporation has the power to acquire, own, and convey property, to sue and be sued, and such other powers of a natural person that the law may confer upon it.”

(www.yourdictionary.com)

Worldwide, the campaign to properly tax companies hots up. 500 years after the Dutch East India Company issued shares (and joint stock companies can be said to have been formed well before that date), the part that companies play in society is still not resolved or even understood by most. Many argue that companies should not even be seen as independent entities for tax purposes but, rather, we should see the people behind them (shareholders and staff, mainly) as due for tax on receipts from companies.

That argument treats society as a game – where the simulated rules can be played out on a computer (a bit like econometricians think of economics). It is not credible in reality as businesses make decisions as businesses and act as independent entities as complex adaptive systems within the overall societal environment. Those calling for zero tax for companies ignore the fact that the biggest fund providers to politicians are businesses and business coalitions. Business (through companies) may well be the main instigators of economic progress in a market-oriented world. We now believe that the market (the nearest equivalent in economics to biological evolution) works better than the alternatives. Companies, which are provided with risk limitations through joint-stock ownership, are central to the market.

But….Is the Company Real?

Well, companies can be defined as a collection of people joined together for a business enterprise. Under laws such as the 2006 Companies Act in the UK, companies of various types are given legal definition in their own right. They have privileges and obligations under the law – even though directors of companies may also have individual responsibilities should the company not perform within the law.

The paradox is that companies are (in law) independent and “living” but, in fact, are, of course, artificial. This proves a difficult concept for individuals in society and for lawmakers, but the history of humankind is bound up with people joining together in groups and governments (from dictators to democracies) trying to legislate for them.

Companies are merely an artificial group legislated into being amongst many others that operate directly with individuals and other artificial and legislated groups (such as other companies and trading with governments). They represent a part of our social fabric as a paradox of society – an artificial group which binds together its individuals into group decisions and group impacts on the rest of society.

A company is a complex adaptive system (CAS)

Initially, a company is formed by key individuals that are hard to separate from the company itself – it may be one person who sets up a business. The business is formed to provide a good or service to society and to reap certain rewards in return. John Kay wrote in 1998  about why a company exists and his thoughts on what makes a good company (these days, a sustainable business).

It is estimated that 70% of companies fail within five years of start-up. Those that survive, become in a relatively short period, very different from the individual that started them. As soon as managers are brought in to assist, the company becomes more “complex” and decision-making is more group oriented but not centralized. The company becomes a system unto itself where most decisions are taken by its staff at all levels and continuously.

If a company goes “public” (with its shares traded), then there is also a divorce between the owners and the managers. Owners operate in the stock market casino – with little or no relationship to the company except insofar as it pays dividends or the share value rises or falls. This separation of ownership and management (and the rewards due to each – a special problem in the finance industry where employees at the top level have usurped the risk parameters and receive high returns for no capital risk) is a potential friction and another level of complexity that society still wrestles with (see John Kay’s more recent work for the UK government).

The complexity of a company’s make-up does not hide the fact that a company operates as a distinct entity – a complex adaptive system (CAS) made up of individuals but (like a City) operating without central direction in ways that impact those around it in a multitude of ways. Companies impact through enterprise and innovation, through motivation, through marketing, through involvement with other companies, through its customers and the environment. It does not operate as individual activities of each of its staff individually but as a collective – as a CAS.

Companies and Society

This has been recognized for centuries and most now understand that anything like a company – despite the corporate paradox – has to be treated in law and taxation as if it had a life of its own. Such treatment includes taxation as much as health and safety, labour laws, environmental laws, trade description laws (e.g. not supplying horse meat instead of beef), data protection and customer protection. Society’s interaction with companies means that staff, consumers and suppliers and anyone else affected by companies (such as people those impacted by companies located in their area, those who oppose the lobbying of companies etc) require that companies are treated like the rest of us – society demands that companies face legal requirements and that includes taxation.

The G20 has now committed to proper tax treatment but our governments need to go further. Companies provide innovation and are the mechanism that a market economy uses for prosperity – at least in pure GDP-related terms (another issue).

To make this real, we have to understand that society sees companies as real entities that have a full part to play in the society of the 21st century – not an artificial entity set up but a full system in itself that has legal and moral authority and responsibilities.

To tax is not an issue – of course companies have to be taxed and taxed fairly and properly in the same way that companies should be held to account over natural resource exploitation, health and safety laws and over reputation (no horsemeat in products unless advertised as such). Only in that way will the rest of society (increasingly aware of its rights) enable companies to reap the benefits of their success and be enabled to continue to innovate sustainably.

Do Companies Exist???

David Cameron is an astute politician and he understands that, at last, there is a popular movement for equity in taxation. This equity includes companies paying a reasonable share of profits. Ian Birrell in The Independent sees this as the start of a movement but this is a campaign that people like Richard Murphy have waged for many years.

True, much of the publicity around his work and that of organisations like the Tax Justice Network and Action Aid have revolved around tax and the developing world. This is where multinationals – especially in the energy and mining sectors – have often connived with governments with a corrupt result that siphoned off hundreds of billions of dollars from the state into the pockets of individuals, elite groups and corporates.

The Dodd-Frank Act – and its focus on country-by-country reporting of tax in such areas – was aimed at opening up governments and companies payments.

However, the taxation effects of tax havens, low tax jurisdictions and multinationals with expertise in moving their tax affairs wherever they want has also created the opportunity for such multinationals to pay if they want, where they want. Organisations like the Institute of Directors, whose members are mainly smaller companies with less multinational options, have recently come out in favour of zero corporate tax rates – on the basis that it is people that should pay tax, not companies.

What’s a Company for?

There are many who believe that a company should not pay taxes – that the market economy needs to ensure that companies are free (within the law) to grow and prosper and that their assumption of human qualities (they are seen as entities under the law) is a fiction. It is people that need to be taxed – not companies and the IoD, for example, in its paper “How to get rid of Corporation Tax” (written following a similar paper from the 2020 Tax Commission) strongly advocates the elimination of all corporation tax as the company is a mere conduit for shareholders, staff etc who should pay all the tax on disbursements from the company.

This begs the question about the essential qualities of a company in a market economy – what is it that makes a company different from an individual – why shouldn’t it pay tax?

Limited liability provides individuals with the scope to take risks. It is a formula from which individuals seeking to build a business can bring in investment knowing that the only requirement to repay (if managing a legally proper business) is limited to the value of the shares as well as any loans taken out. It is limited liability that was fully developed in the Netherlands in1602 when stock was tradable on the Amsterdam Stock Exchange that gave the push to enterprise in Europe. Taken up by the British, it heralded the industrial revolution.

Joint stock companies (having limited liability) were the original, defining force that differentiated companies from individuals pursuing business opportunities. Now, most business is done with limited liability.  Governments have lost track of the ability of such joint stock companies to register in whatever jurisdiction they want and to appoint Directors that have nothing to do with the business – often purely there to hide ownership.

Clearly, companies have a huge presence. Their marketing ability is as the company – not the individuals that are behind it. Advertising and brand management is aimed at providing the public with an identifiable face. A company relies on its customers seeing it as a tangible and identifiable organization with which customers can do business. It has a legal basis (and can take action as such and be actioned against as a result) as well as a moral requirement – the advent of CSR is merely a tangible outcome of the way that companies are seen to be real and impact the environment and society in many ways.

If it quacks…..

We all know that companies are the centre of entrepreneurship and product and service creativity. In a market economy, the rise of joint stock corporations have worked to de-risk investments so that competition has been developed and economic growth maintained since the early 1800’s. This growth has developed some enormous corporations in businesses as wide as energy, food, utilities, construction, defence and aerospace, pharmaceuticals and beyond. Every area of opportunity is mined by the evolution of companies across the globe. Governments have progressively sought to assist business but, under pressure from society (people) laws have been passed which inhibit them to what society believes are proper norms.

These laws include health and safety and employment laws but also include tax laws. As a result, companies make decisions on where to locate – although this often includes where it needs to sell as much as where it can find skilled staff or suppliers.

Apart from rogue traders, set up with the need to hide its affairs within foreign jurisdictions and behind false Directors, many MNC’s (multinational corporations) are able to move their profits around by manipulation of licensing and other features. Rather than pay tax on profits in the areas in which they make the money, accountants can provide companies with boltholes in which the rates of tax are very low.

The IoD and others believe that companies are not real – that Governments should give up on them and rely on the payments they make to people on which tax should be paid.

The question arises: if a company is a distinct entity in law; if it can be held responsible for its impact on the environment, its impact on people, its duty of care to customers – why, oh why, should it not pay taxes? Why should society not look to some repayment from the company itself – which benefits hugely from joint stock activities as well and huge benefits that are introduced for companies such in terms of infrastructure, government regulations, and a myriad of other incentives – rather than (in this instance only) having to seek tax purely from receivers of income from companies. Taxing companies is, in principle, correct as it is the company that derives the income from a location.

If tax is to be separated, then the long-term outcome for companies would be potentially the loss of other benefits (such as joint-stock arrangements) as the legal distinction becomes blurred. Not just the thin end of the wedge – but a potentially disastrous change.

Companies have to play their part

If companies exist in law as distinct entities, which they do worldwide, then it is reasonable that they face up to the reasonable demands of the society in which they operate. Company law, however, may set up companies as distinct but the reality is that the company has no moral code except that which society imposes. People have moral codes, companies (which are organisations of people) do not. CSR is reactive to society, not pro-active and while companies have a need to become sustainable (in terms not just of resources but sustainable in terms of the relationship with its customers and the societies in which they operate) it is extremely rare for them to lead – to take such societal risks.

This is true in most areas. Health and safety leaders in companies were years ahead of the legal changes in places such as California but were reacting, quite properly, to likely long-term changes. Those that did so were ahead of the game when laws changed in areas such as environmental restrictions.

This reactive ability (changing as the environment changes in an evolutionary way) makes the best companies resilient – sustainable. It shows they are real entities as much of society as any other organizational form or the individuals that self-organise around them and within them. Companies are a part of society and should contribute to society as a key part of it. This means that opting out of a crucial element of the system – taxation – is ludicrous on grounds of the companies’ relationship with society – whether that opting out is legal or not.

The dangers are obvious. The crack in society would be potentially dramatic – companies would be seen to have no fiscal contract with society. This may well be the case for MNC’s now but the public backlash is starting to inhibit their ability to prosper in this environment. Companies that properly pay their tax are now selling this proposition to their customers – companies such as J Sainsbury whose pride in paying proper company tax in the UK is seen in distinct contrast to those MNC’s like Amazon, Starbucks and similar. The latter is threatening to disentangle itself from future investment in the UK if David Cameron (and his “time to smell the coffee remarks”) persists in trying to get them to pay tax where they trade rather than using licensing and royalties to hid their true profits.

Companies are a key part of society. They have to act as such and not just contribute to society solely through CSR documents. They have to be seen to contribute and tax is one of the most obvious manifestations of that contribution.

Let tax be paid where the trade is made

Let’s end the notion that companies should not pay corporation tax and let’s get on to the next step of the ladder – working out how to ensure that royalties, tax havens, tax schemes, fake Directors and the like are no longer tolerated and that tax is paid where the trade is made.

 

See: Do Companies Exist – Part II