Shareholder Value and Current Financial Crisis: An Analysis of the Relationship Essay
Sorry, but copying text is forbidden on this website!
Corporate governance in a particular firm is inevitable for its administration, policy making and overall health. In other words, ‘Corporate governance affects the development and functioning of capital markets and exerts a strong influence on resource allocation.’ Not only does it conduct the present running of a firm but it also has a futuristic outlook and a good corporate governance system encourages innovations in the firm.
There may be counter arguments that the existing cut-throat competition in the market can be left for taking care of good governance in a corporate because one lacking good governance will definitely be thrown out of business for under-performing.
Then why is there the need to formulate and execute certain benchmark of principles and policy intervention for good corporate governance.
But there are certain situations where competition can’t prevent mal-practices. There are cases where the managers get corrupt and embezzle shareholders’ profits. The product-competition threat has no bearing on such mal-practices. Hence a policy intervention is indeed justified.
Adopting of a certain form of corporate governance model also helps in comparing the performance of economies- the ones that have a set model of corporate governance with the ones that don’t.
One such corporate governance model is the shareholder model of corporate governance. Also known as the Anglo-American model of corporate Governance, it is one of the most widely accepted and adopted models of corporate governance. This present paper deals with the nuances of the model and whether or not this model had any role to play in the last financial crisis. If it indeed had a hand in the building up the debacle, the paper will look into the ways it did so.
Chapter 1: Understanding the concept of shareholder value.
The shareholder value hypothesis is one of the key hypotheses of the financialized capitalism of the 1980s onwards. In their influential study of globalisation, shareholder value and the convergence of company law, Hansmann and Kraakman present the shareholder model (also known as the Anglo-American model), more or less as a fait accompli, their comparative corporate governance argument proposed that there is “no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value’.In other words they say that in all the convergent developments across the world in the field of corporate governance, the most significant is that of the convergence towards shareholder model.
In order to understand the reason behind such convergence and wide acceptance of shareholder value model by the corporate firms, one has to first understand the concept of shareholder value and thereafter the corporate governance model based on it.
1.1 Shareholder value: Origin and Meaning.
In the 1960’s the United States economy was dominated by giant corporations which believed in earning profits and retaining both the profits, and the employees of the Company. Shareholders were seen not just as passive, but as irrelevant to the running of the company. But towards the 1980’s due to growth of larger corporations and rise of new competitors, retaining and reinvesting the profits earned by the company became cumbersome.
By the 1970s, due to poor performance of the companies, agency theorists agreed that there was indeed a need for takeover market, functioning as a market for corporate control which could discipline the managers to run their companies properly. Return of corporate stock was supposed to be the indicator of superior performance of a certain company. Therefore till the 1990’s the companies worked incessantly to ultimately become adept at creating more and more shareholder value. For this, they diverted from their earlier belief in retain and reinvest to downsize and distribute. While distribute refers to the already mentioned returning of corporate stock and thus reflecting good health of the Company, downsize meant job-cutting of employees, so that the extra profits could also be furthered to the shareholders.
In other words, maximizing shareholder value is enriching the shareholders through either issuing dividends by the company or increasing the stock price of shares of the company in the market.
1.2 Shareholder model of Corporate Governance.
As already discussed, each Company has to be run on a certain model of Corporate Governance. Amongst the many forms and models of Corporate Governance, shareholder model is a prevalent one.
Now what is this shareholder model of Corporate Governance? The so-called ‘shareholder value’ norm is not simply or even principally a legal rule or principle. It is above all a practice which came to shape managerial behaviour in large, listed American and British firms, and increasingly those in other jurisdictions, in the last decades of the twentieth century.
In the words of Hansmann and Kraakman, who offer the most lucid and fundamental explanation of shareholder model, ‘The principal elements of this consensus (shareholder value model) are that ultimate control over the corporation should be in the hands of the shareholder class; that the managers of the corporation should be charged with the obligation to manage the corporation in the interests of its shareholders; that other corporate constituencies, such as creditors, employees, suppliers, and customers should have their interests protected by contractual and regulatory means rather than through participation in corporate governance; that non-controlling shareholders should receive strong protection from exploitation at the hands of controlling shareholders; and that the principal measure of the interests of the publicly traded corporations shareholders is the market value of their shares in the firm’.
The rationale behind justifying this form of Corporate Governance is three-fold.
The ownership argument asserts that shareholders, as property owners, ought to get their just deserts, or a variant and that shareholder value arises from residual claims. This is one of the lesser persuasive of justifications for shareholder model. The main criticism to this approach is the superficiality of ownership of a Company by the shareholders. Shareholders do not have access to the company’s assets. Nor does company law confer much more than limited rights of control and governance to the shareholders. Hence shareholders are not the owners of the Company in truest sense.
The next approach to genesis of shareholder model is the democratic argument. Shareholder model aims at democratising the capitalism. Practically if a business fails it is the shareholders’ savings which are destroyed, so they’re the primary stakeholders of our company. Hence the managers and directors are bound to be the most careful towards the interests of the shareholders. It can be compared to a democracy because, in democracy there are elected representatives of people who have entrusted their rights in the hands of the State. Similarly the shareholders have entrusted their savings and investments in the hands of the directors and hence principally they should hold the power to run the Company too.
The third approach towards understanding shareholder model is the efficiency approach. This is one of the most swaying argument advocating shareholder model. By precedents and current examples it’s seen that companies with such a shareholder model perform and outdo the others (based on alternative models). Hence these companies by virtue of being more efficient will build up on more profits and drive the less efficient ones out of the game.
In the notable article by Hansmann and Kraakman, the end of Corporate History, they have in detail discussed this model. Their understanding of the origin and catching up of this model like an epidemic can be summed up in the following words. The best means to achieve the end of social welfare through a corporation is to pursue the interests of its shareholders. The remedies for other stakeholders should lie outside. The force of logic, the force of example and the force of competition provide the backbone for justifying and adopting shareholder model of corporate governance. While the force of logic is loosely based on the ownership and efficiency argument discussed above, force of example and force of competition are backed by illustrations from the real business world as to how corporate with shareholder model do better than others, so much so they drive the other competitors out of the competition itself.
Therefore, an overview of what shareholder value is and what are the salient features of a company following shareholder model of Corporate Governance are available from the above discussion.
Chapter 2: understanding the current financial crisis.
the global financial crisis from 2008-12 has been seen as economists as one of the worst financial crises since the Great Depression of the 1930’s. It was characterized by collapse of large financial institutions, bailouts of banks by national governments, large scale unemployment, and collapse of stock markets and also a considerable decrease in consumer wealth. The genesis of the crisis can be traced back to early 1990’s when extremely liberal monetary policies were formulated and towards the end of the decade and beyond such policies got out of hand and unregulated and led to the fiasco of the Great recession.
Any explanation of the global financial crisis begins with explaining the real estate bubble burst in the United States of America. In the last part of the 1990-2000 decade the banks started dishing out really low interest rates. This propelled the people to invest in real estate field heavily. There was a burgeoning real estate till 2004 after which the banks suddenly increased the interest rates. There was a fall in house prices and hence the entire mortgage backed loans which the banks and other financial institutions enthusiastically took up, failed miserably and they had to suffer huge losses. This spiralled the US economy into deep recession and it goes without saying that in no time affected the other economies in the world too.
According to Chris Bummer, a professor of Law at the Georgetown University of Law, ‘the 2008 global financial crisis occurred in large part due to exceptionally high amount of leverage among institutional investors and the public at large’. Leverage on simple terms refers to multiplication of gains by employing various methods of taking loans; buying fixed assets etc. this mad rush for leverage by small and big institutions alike caused mushrooming of various financial products. The consumers also blindly invested in these schemes without actually knowing what was actually contained in these products.
So, the institutions which were serving as both insurance and speculative credit source were pretty much unregulated. There was increased murkiness about the kind of policies they formulated for themselves and generated for their consumers.
The impact of the recession was felt in all aspects of economy. There was a dip of as much as 3% in GDP of advanced economies and that of 2% in developing countries. There was widespread unemployment, the percentage in advanced economies being 8-9%. Though the situation is pretty much under control and the affected economies are recovering from the jolt but the scars of this crisis will remain for a long time to come.
Chapter 3: Increasing Shareholder Value contributed to current financial crisis: how or how not?
In Alan Greenspan’s testimony to the US Congress’ House Government Oversight Committee in October 2008, he said, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief.”
There are various strategies adopted by the corporate to augment the shareholder profits. This chapter discusses how the methods employed to achieve the same went off the track and were the causes of few of the major corporate scandals. One of the aims of shareholder modelled companies is to get more and more investments. An investor would obviously prefer to invest in a healthy company; hence the accounts have to be sturdy. Manoeuvres with deceitful intention and accounting fraud ( case of Xerox); improper accounting, deviation from accounting principles with deceitful intention, leveraging its own share to raise debt for expensive acquisitions (case of WorldCom), stretching the limits of accounting by misusing the limitations of accounting, lack of transparency, and mal-intention to project a rosy picture of performance (case of Enron) are results of executives hysterically and desperately trying to make figures look good in order to make the company flourish. Shareholder value maximization would also include attempts by the executives to get heavy investments to the company, hence aggressive acquisition strategies may lead to anomaly in the corporate. (Case of Tyco)
Shareholder model’s greatest strength and its greatest weakness are its single- minded focus on value maximization. Every firm tries to achieve this corporate objective function through careful planning and implementation of investment, financial and dividend decisions. When decisions are made to maximize the stakeholder’s wealth within the constraints of being a good citizen, the objective function seems fair. When focus moves to a particular group of stakeholders, then more is the chance of stepping out from the shoes of a good citizen. As a result, the corporative objective function fails to reflect positive results in the long term.
Had all the board of directors being successful in their assigned role of protecting the firm’s stakeholders, the economy would not have witnessed this crisis. Maximization of wealth not only increases the shareholder’s wealth but also serves the interests of different groups directly or indirectly related to them. Since it emits undue pressure on the agency/mangers, they will be tempted to resort to unethical and unnatural means so as to exhibit an appealing picture. In the long run, these agents of shareholders may resort to means that are detrimental to the shareholders themselves.
Financial maximization principle (shareholder value maximization) itself offers no real ethical guidance in corporate governance. Hence the situations of imperfect market, incomplete contracts, information asymmetries etc. cannot be ruled out in the present set up.
One of the pillars of shareholder value model is the function of managers and executives in the firm and their constant aim of maximizing benefits for shareholders. Conflict of interests arises between shareholders and managers in three broad areas. Firstly, executives enjoy as well as exploit the perquisites provided to them. Secondly, executives are more risk averse in decision making and aims at better compensation as a trade-off. Lastly, the executives are more interested in taking decisions having short-term impact rather than viewing at a long –term perspective.
In the mad rush to maximise wealth for shareholders, a side effect that surfaces is account fudging. In fact in recent times, in all the major corporate scandals account fudging has been reported. The cases of Enron and WorldCom give us evidences that unfair and inefficient information are strong enough to shake the whole financial system. Closer home is the case of Satyam computers. Mr. Ramalinga Raju, the chairman of the company has disclosed that he was compelled to fudge the accounts to show high returns to boost continuing investor confidence. Apart from creating chaos at a very big scale, this account considerably affects the small time investors. When the company is indulging in any type of artificial stock market oscillations, it is always the small investor who is sucked into this speculative game and losses eventually when the collapse begins.
In very simple words, power corrupts and absolute power corrupts absolutely. So on one hand when shareholders have a firm grip on activities of the managers of the firm, if the shareholders so deem, that a certain project isn’t doing as well as the other similar projects in the market, they might force the managers to abandon the same, because it does not create shareholder value.
So even if a project is profitable in itself, due to shareholders asserting their whims and fancies, it has to be abandoned. The managers are forced to invest in short term projects and leave aside the long-term value maximization. In the last global financial crisis, one of the major setbacks was suffered by the economies due to shadow banking system, which allowed short-term debts to purchase long-term assets. So any disruption in credit market forced them to sell long term assets at lowered prices.
As it is known that due to the strict vigil of the shareholders, the management of the company can be altered if the need be so. Hence often the shareholder activities lead to takeover of an ill-managed company. While empirical data shows that hostile takeovers do better in managing the companies than takeovers by consent, but the performance is not extraordinary. It is just above average. Also if hostile and agreed takeovers are taken together, cumulatively, the returns for the shareholders still remain below what is required. As per Nouriel Roubini, ‘Bank takeovers worsened the financial crisis by making firms that were already too big even bigger.’ This is because when bigger entities fail, the impact felt on the market is very high, so it is more prudent that such big banks are divided into smaller entities after take over.
These takeovers also lead to downsizing. As a result of that many employees lose their jobs, one of the most critical issues in the last global financial crisis.
On summarizing the causes for the latest financial crisis, unregulated financial institutions figure significantly. So even though one of the primary targets of shareholder model is to keep a check on what policies certain corporate is actually developing and carrying out, it failed miserably in doing the same. This calls for a revamp of shareholder model of corporate governance. Or if looked at it differently, probably the shareholders in the haste to maximize their profits gave tacit consent to do the same. Another possibility could be that shareholders are not just vigilant enough and do not care immensely about how a corporate is functioning and are just satisfied with the annual returns that they get on their investment. This would mean the entire focus on shareholder model is inherently flawed and instead the focus should be on stakeholders as then an all-round hold over the managers and executives will be maintained and there will be less scope for mal-practices.