Post by Sapphire Capital on Aug 20, 2008 8:19:48 GMT 4
Corporate Property, Value Maximization, and Shareholder Primacy
Robert J. Rhee
University of Maryland - School of Law
U of Maryland Legal Studies Research Paper No. 2008-29
Abstract:
The prevailing theory of corporate law regards the corporation as private property of its contractual constituents. The function of a firm is simple: a firm converts input into output, thereby generating cashflow that is apportioned to various claimants per contract. This function requires collaborative effort, and collaboration is impossible without an understanding of the relationships among factors of production. Based on these premises, the prevailing corporate law theory suggests that a firm is a "nexus of contracts," a web of express or implicit contracts governing each contractor's obligation in the venture and interest in the firm's cashflow. Under this view, the firm is seen less as an independent entity, and more an aggregate of private property interests as defined by the contractual rights of each constituent.
This "property" model of the firm is an internally coherent theory that has gained wide acceptance in the economic and legal academies. If, however, the concept of private property right is to be viewed as something more than a rhetorical device, there are troubling inconsistencies between the theories of the firm and property. The economic theory of property rights posits that property rights function to internalize the cost of externalities, which promotes efficiency and social wealth. The continuing debate on the purpose of a corporation fundamentally concerns how this cost should be allocated, for it is clear that if all effects of the firm's activities are internalized per contract there would be no debate. The concept of shareholder primacy with its focus on profit incentivizes externalization of cost to the extent it increases profit. Contractual constituents such as employees and creditors can be harmed, but these harms can in theory be redressed per ex ante contract negotiation. More problematic are third-party effects and the limited liability shield. This problem ranges from localized harms the unfortunate few to global effects on the many. The justification for limited liability is that internalization of costs is greater than the externalities associated with the firm's profit making activity. If so, however, this is an argument for the creation of communal vis-a-vis private property rights. The communal nature does not mean equal rights of all participants, but it does mean that there is no unitary right to control, exclude and consume the corporate property, which accurately describes the nature of corporate control.
The externality of profit making is also manifest in the arena of takeovers. While target shareholders typically benefit from the acquisition premium, the effects of takeovers on other constituents, such as employees and communities, are adverse. From a contractarian view of the firm, takeovers can be seen as the disaggregation or reconfiguration of the "nexus of contracts." Although the transaction cost expended to create the nexus of contracts is a cost as it is conceived in the accounting convention, the nexus of contracts - the special order and arrangements of the contractual understandings amongst the factors of production - constitute an essential asset of the firm. In much the same way that order is created per expenditure of energy in the natural world, the order of contractual arrangement is the basis of production. Each firm then has entropy as measured by its contractual orderliness. As the nexus of contracts disaggregates or reconfigures in furtherance of the business combination, the entropic nature of the firm changes. These changes are marked by the opportunity cost of the current state of order and additional expenditure of transaction cost. Restructuring charges are simply the most apparent aspect of these changes. Given these realities, it is expected that many takeovers do not enhance wealth, but rather diminish it even though target shareholders typically profit from the acquisition premium.
The conflict between the private property model of the firm and the theory of property rights is significant. This contradiction between shareholder primacy and the theory of property rights cannot be avoided through explanatory elision, such as the view that profit maximization and externality are optimized in the longterm. Such explanation requires faith in the proper functioning of the market, a conclusion that suggests a restatement of the premise.
This Article argues that the purpose of a corporation is not to maximize profit, but to increase firm value. The two goals are seen as coterminous in that both tend to maximize social wealth. But profit is a distributional concept whereas value is an aggregate measure. Under standard financial theory, the value of a firm is the sum of the discounted future cashflow. The concept of value maximization is independent of a normative view of distributional priority. Beyond this narrow financial definition, value can be seen from the perspective of property rights in a political economy. The nature of the claims against corporate property is ambiguous at best. The shareholder's property is a speculative contract that is bought and sold among fellow speculators, and his claim against the firm is only in the nature of the firm's guarantee of liquidity in the event that market liquidity dissipates, i.e., rights in bankruptcy. "Ownership" of the firm is awkwardly characterized in terms of private rights for none of the rights of property qua the firm (exclusion, control and consumption) inures in a common share. The right is better described as communal in nature for the power to exclude, control and consume are spread to the community of participants. Certainly, this is an apt description of the observation of Berle and Means that ownership and control are diffused in the modern public corporation.
Under this conceptual framework, equityholders are not the "principal," connoting something akin to ownership, as suggested by the nexus of contracts theory of the firm, but are a monitoring device that enhances firm value. Corporate law allows shareholders, like creditors, to monitor agents (managers), which minimizes agency cost qua the firm, which is better described as communal property. Thus, the financial benefit of shareholders is not the end of corporate law, but rather equity as a class of capital can be seen as providing a value enhancing function.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1152762
Robert J. Rhee
University of Maryland - School of Law
U of Maryland Legal Studies Research Paper No. 2008-29
Abstract:
The prevailing theory of corporate law regards the corporation as private property of its contractual constituents. The function of a firm is simple: a firm converts input into output, thereby generating cashflow that is apportioned to various claimants per contract. This function requires collaborative effort, and collaboration is impossible without an understanding of the relationships among factors of production. Based on these premises, the prevailing corporate law theory suggests that a firm is a "nexus of contracts," a web of express or implicit contracts governing each contractor's obligation in the venture and interest in the firm's cashflow. Under this view, the firm is seen less as an independent entity, and more an aggregate of private property interests as defined by the contractual rights of each constituent.
This "property" model of the firm is an internally coherent theory that has gained wide acceptance in the economic and legal academies. If, however, the concept of private property right is to be viewed as something more than a rhetorical device, there are troubling inconsistencies between the theories of the firm and property. The economic theory of property rights posits that property rights function to internalize the cost of externalities, which promotes efficiency and social wealth. The continuing debate on the purpose of a corporation fundamentally concerns how this cost should be allocated, for it is clear that if all effects of the firm's activities are internalized per contract there would be no debate. The concept of shareholder primacy with its focus on profit incentivizes externalization of cost to the extent it increases profit. Contractual constituents such as employees and creditors can be harmed, but these harms can in theory be redressed per ex ante contract negotiation. More problematic are third-party effects and the limited liability shield. This problem ranges from localized harms the unfortunate few to global effects on the many. The justification for limited liability is that internalization of costs is greater than the externalities associated with the firm's profit making activity. If so, however, this is an argument for the creation of communal vis-a-vis private property rights. The communal nature does not mean equal rights of all participants, but it does mean that there is no unitary right to control, exclude and consume the corporate property, which accurately describes the nature of corporate control.
The externality of profit making is also manifest in the arena of takeovers. While target shareholders typically benefit from the acquisition premium, the effects of takeovers on other constituents, such as employees and communities, are adverse. From a contractarian view of the firm, takeovers can be seen as the disaggregation or reconfiguration of the "nexus of contracts." Although the transaction cost expended to create the nexus of contracts is a cost as it is conceived in the accounting convention, the nexus of contracts - the special order and arrangements of the contractual understandings amongst the factors of production - constitute an essential asset of the firm. In much the same way that order is created per expenditure of energy in the natural world, the order of contractual arrangement is the basis of production. Each firm then has entropy as measured by its contractual orderliness. As the nexus of contracts disaggregates or reconfigures in furtherance of the business combination, the entropic nature of the firm changes. These changes are marked by the opportunity cost of the current state of order and additional expenditure of transaction cost. Restructuring charges are simply the most apparent aspect of these changes. Given these realities, it is expected that many takeovers do not enhance wealth, but rather diminish it even though target shareholders typically profit from the acquisition premium.
The conflict between the private property model of the firm and the theory of property rights is significant. This contradiction between shareholder primacy and the theory of property rights cannot be avoided through explanatory elision, such as the view that profit maximization and externality are optimized in the longterm. Such explanation requires faith in the proper functioning of the market, a conclusion that suggests a restatement of the premise.
This Article argues that the purpose of a corporation is not to maximize profit, but to increase firm value. The two goals are seen as coterminous in that both tend to maximize social wealth. But profit is a distributional concept whereas value is an aggregate measure. Under standard financial theory, the value of a firm is the sum of the discounted future cashflow. The concept of value maximization is independent of a normative view of distributional priority. Beyond this narrow financial definition, value can be seen from the perspective of property rights in a political economy. The nature of the claims against corporate property is ambiguous at best. The shareholder's property is a speculative contract that is bought and sold among fellow speculators, and his claim against the firm is only in the nature of the firm's guarantee of liquidity in the event that market liquidity dissipates, i.e., rights in bankruptcy. "Ownership" of the firm is awkwardly characterized in terms of private rights for none of the rights of property qua the firm (exclusion, control and consumption) inures in a common share. The right is better described as communal in nature for the power to exclude, control and consume are spread to the community of participants. Certainly, this is an apt description of the observation of Berle and Means that ownership and control are diffused in the modern public corporation.
Under this conceptual framework, equityholders are not the "principal," connoting something akin to ownership, as suggested by the nexus of contracts theory of the firm, but are a monitoring device that enhances firm value. Corporate law allows shareholders, like creditors, to monitor agents (managers), which minimizes agency cost qua the firm, which is better described as communal property. Thus, the financial benefit of shareholders is not the end of corporate law, but rather equity as a class of capital can be seen as providing a value enhancing function.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1152762