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Reshaping the Ownership Relationship Towards a more
Ethical Corporation
Marco G. D. Guidi*, Joe Hillier, Heather Tarbert
Division of Accounting and Finance, Glasgow Caledonian University, Cowcaddens Road, Glasgow,
G4 0BA, UK
Keywords/phrases: open and closed corporations, employee ownership, residual risk-bearing (ownership)
and decision-making (control), residual and ‘moral debt’ claims, agency costs, distributive justice,
maximizing the firm value to society, stakeholders and shareholders.
Acknowledgement: All errors and omissions are authors’ responsibility.
*Corresponding author:
Tel.: 0044 (0) 141 331 8076 Fax: 0044 (0) 141 331 3360
E-mail address: marco.guidi@gcal.ac.uk (M. G. D. Guidi)
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Abstract
We examine the issues relating to the most appropriate form of firm ownership
structure that will maximize the firm’s value to society. The nature of the firm can be
generally defined as an open corporation with separate residual risk-bearing (ownership)
and decision-making (control) functions. In contrast, a closed form of corporation can be
defined has having common ownership and control functions. Our findings suggest that
the maximization of firm value to society is more readily achieved through a closed
corporation type formation, such as employee owned corporation or partnership, that
fairly distributes all claims including residual and ‘moral debt’ claims rather than an open
corporation with large conflicts of interest and agency costs.
2
1. Introduction
The nature of the firm can be generally defined as an open corporation with
separate residual risk-bearing and decision making functions (Fama and Jensen, 1983a,
1983b). In other words, outside shareholders of the firm do not need to play an ‘active’
role in the organization and their residual rights are alienable without restriction (Fama
and Jensen, 1985). In contrast, a closed corporation can be defined as having residual
claims that are largely restricted to important internal decision agents (Fama and Jensen,
1983a, 1983b, 1985). That is, there is no separation of residual risk-bearing (ownership)
and decision-making (control) functions.
It is argued that increasing equity ownership for executives with appropriate
incentives and corporate governance schemes ultimately increases shareholders’ wealth
and the firm’s performance through what represents a new organizational form (Jensen,
1986; Jensen and Warner, 1988). However, the separation of ownership and control in
open corporations also requires senior management to delegate decision rights to
employees but “employees, however, are not owners: they cannot sell company property
and keep the proceeds Therefore, employees have fewer incentives to worry about the
efficient use of company resources than do owners” (Brickley et al., 2002, p1825). Thus,
there is an argument allowing all inside stakeholders to have equity ownership, which
will help to reduce conflicts of interest by reducing agency costs1 through the common
sharing of risk-bearing and decision-making functions. In fact, Chang and Mayers
1 Agency costs arise because the nexus of contracts that define the firm are not costlessly written and enforced (Jensen and Meckling, 1976; Fama and Jensen, 1983b; Brickley et al., 2002).
3
(1992); Rooney (1991); Morck et al., (1988); Demsetz and Lehn (1985) find evidence2
that Employee Share Ownership Plans (ESOPs) have positive effects on firm
performance by reducing conflicts of interests (agency costs) associated with the
separation of risk bearing and decision functions. However, there is a caveat in that
Gordon and Pound (1990) find the wealth effect of ESOPs can either be positive or
negative depending on how ESOPs affect the incentive and controls mechanisms of a
firm.
Employee ownership is a growing phenomenon in business, however, it is not yet
well known or understood by the public, business/finance communities, or the academic
community (typically, textbooks either do not refer to such entities or provide a sentence
or two). In the UK alone wholly employee-owned corporations account for around £20bn
worth of turnover and one of the largest is John Lewis Partnership (JLP, employing
around 65,000 people with a turnover of £5.1bn in 2006). The ultimate purpose of the
John Lewis Partnership is defined in its constitution – “the happiness of all its members
through their worthwhile and satisfying employment in a successful business” (John
Lewis Partnership plc, Annual report and accounts 2006). In US alone there is around
11,000 firms that have ESOPs and around “23 million Americans own stock in their
employer, and perhaps 10 million own options” (Rosen et al., 2005, p9). In fact,
Americans from the late 1910’s onwards like Kelso, Adler, Eliot (Harvard President),
Brookings (Brooking Institute), and John D. Rockefeller Jr. supported and advocated
employee ownership (Rosen et al., 2005; Blair et al., 2000). In fact Rowlinson et al.
2 Although, Demsetz and Villalonga (2001) argue that the complexities of the various ownership interests makes the evidence from these previous studies less likely to result in similar findings for all firms.
4
(2006, p682) cite that Adam Smith and John Stuart Mill “opposed the separation of
ownership from control and were highly critical of joint stock companies” (See also
Arnold and De Lange, 2004).
Fama and Jensen (1983b) argue that it is an interesting problem for a firm to
determining when it is more efficient to separate or combine the decision-making and
risk-bearing functions. In fact, Fama and Jensen (1983a, 1983b) concede that a closed
corporation that restricts residual claims to mainly important decision makers can avoid
agency cost associated with the separation of risk-bearing and decision-making functions
that is normally found in an open corporation. There seems growing evidence that to
provide equity ownership to inside stakeholders will help to reduce conflicts of interest
and thus reduce agency costs by allowing the common sharing of risk-bearing and
decision-making functions. For example, Holderness et al. (1999, p466) argue that an
increase in inside managerial ownership “has to be considered an important development
of US corporate governance since the Great Depression”. Furthermore, Core and Larcker
(2002) find evidence that increasing equity ownership for executives whilst having
appropriate incentives and corporate governance schemes ultimately increases a firm’s
performance. Finally, Chang and Mayers (1992); Morck et al., (1988); Demsetz and Lehn
(1985) find evidence of positive effects of ESOPs on firm performance by reducing
agency costs associated with conflicts of interest between principal and agent.
Fama and Jensen’s (1983b, p7) state that “restricting residual claims to decision
makers controls agency problems between residual claimants and decision agents.”
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Thereby, by giving inside stakeholders rights to residual claims will support bonding and
monitoring within the firm making it less likely for it to deviate from ethical business
decisions and thus reduce its ‘moral debt’ so maximizing its value to society (Guidi et al.,
2007). Wruck (1989); Mikkelson and Ruback (1985); Holderness and Shehan (1985) find
empirical evidence that an increase in insider concentration of private equity ownership
improves a firm’s performance through better governance and incentives schemes.
Therefore, theoretically by increasing insider ownership it is possible to reduce conflicts
of interest that arise with the separation of the risk-bearing and decision-making
functions. This reduction in agency costs is due to exposing inside stakeholders to the up-
side benefits as well as to the downside costs of all business decisions undertaken by the
firm (See Guidi et al, 2007; Stiglitz, 2006; Arnold and De Lange, 2004; Stultz, 1999 for a
more in depth discussion on this matter).
The Scott Bader Commonwealth (SBC) is a good examples of a closed employee
owned corporation that has a constitution, based on moral principles of just distributing
of residual, decision-making and ‘moral debt’ claims with good monitoring, bonding and
incentive schemes that encourages harmonizing of objectives (goal congruence) to all
inside stakeholders (Schumacher, 1993; Bader, 1986; Wilken, 1982). Schumacher (1993)
and Wilken (1982) have discerned that the SBC has replaced private (individual)
ownership rights with a common ownership whereby individuals have specific rights and
responsibilities in the administration of assets (capital). This follows Fama and Jensen
(1983b, p28) argument that due to the role of specific knowledge, which implies private
information, can produce “benefits from better decisions” and this “can be achieved by
6
delegating decision functions to agents at all levels of the organization who have relevant
specific knowledge, rather than allocating all decision management and control to the
residual claimants” as is found in the case of an open corporation with outside
shareholders (i.e. outside residual claimants).
2. Open versus Closed Corporation in the Capital Markets
“We are fully conscious that we must make wealth before it can be distributed…”
The Scott Bader Commonwealth (Bader, 1986, p73).
Employees who may own common shares in an open corporation will receive the
residual claims from such shares which are separable3 and tradable (Fama and Jensen,
1983a). (Fama and Jensen, 1983a, 1983b, 1985) argue that one of the main advantages of
an open corporation’s common stock is the efficiency in spreading residual risk. Fama
and Jensen (1983a); Jensen and Smith (2003) argue that the tradability of an open
corporation’s shares allows for the realization of risk-bearing efficiencies through
diversification in the capital markets. In incomplete capital markets, however, stock
prices do not fully allocate resources through the sharing and transferring of risk
(insurance markets) which is actually borne by inside stakeholder (e.g. employee) has a
real social cost (Stiglitz, 1982). The USA and UK the capital market systems4 are now
3 Copeland and Weston (1992) on the Fisher separation theorem state “Given perfect and complete capital markets, the production decision is governed solely by an objective market criterion (represented by maximizing attained wealth) without regard to individuals’ subjective preferences that enter into their consumption decisions”. In other words, managers only need to know the market discount rate and the cash flows of their investment projects and can ignore specific preferences of their shareholders. 4 Newbery and Stiglitz (1982, p244) point out even in the world of complete markets “insurance markets allocate risk, and goods markets allocate goods; but in the absence of insurance markets, the remaining goods markets have to serve both functions.”
7
more competitive and complete5 than back in the 1980’s. That is, a risk averse employee
with most (if not all) of his/her income generated, by the firm that he/she works for, is
able to buy income protection or unemployment insurance to allow someone else to bear
the financial risk when, for example, the employee is made redundant or is unable to
work. In fact, Acemoglu and Shimer (1999) show that even partial unemployment
insurance6 in incomplete markets, a firm with risk-averse employees will increase wages
and firm production. Since the insurance and capital markets in USA is now more
competitive and complete than in previous years they can now facilitate a set of
contingent claims for specialization of risk-bearing that is more efficient than holding
common residual stock claims alone (Holderness et al., 1999). In other words, today an
individual in a closed corporation and who is risk-averse can, due to the more
competitive market system, find specialized risk-bearing services (insurance markets)
that will allow diversification of the residual risk associated with ownership of non-
tradable shares.
(Fama and Jensen, 1983a; Jensen; 1985) argue that an open corporation survives
because it delivers product and services demanded by consumers at the lowest price.
There is a caveat, in that an open corporation has major organizational problems
associated with the failure of internal control systems (Jensen and Chew, 1995; Jensen,
1989). Thus, to compensate for the less efficient open corporation the capital markets
have promoted takeover activity that has transferred control of corporate resources “to
smaller, more focused – and in many cases private – corporations and individuals, who
5 A market in which there is a distinctive marketable security for each possible outcome. 6 Moral hazard causes fully insured employees to expend too little effort (Arnott and Stiglitz, 1991).
8
returned huge amounts of equity capital to shareholders” Jensen and Chew (1995, p1). In
fact, open corporations have outlived their usefulness in many sectors of the USA
economy (Jensen, 1989). Furthermore, Arnott and Stiglitz (1991) argue that when
significant market failure occurs there is a strong incentive for non market institutions to
develop towards remedying the deficiency. Thus, there now seems a thriving market for
(non-tradable) closed corporations such as private Leveraged Buy Outs (LBOs) financed
by private equity firms7 as well as other more ethical responsible closed corporations8
similar to Scott Bader Commonwealth and John Lewis Partnership. Furthermore, Jensen
and Chew (1995) argue that political pressure in the USA as led to less effective capital
markets for corporate control through Congress, court and regulatory intervention. They
argue that certain features of LBO firms will help reform internal corporate control
mechanism9, these are: effective decentralization; higher pay-for-performance; smaller,
more active, and better informed boards; and significant equity ownership by board
members as well as managers.
The evidence from USA and UK capital markets is that an open corporation with its
large conflicts of interests and high agency costs due to principal-agent problems seem
less attractive (Gaudhoum et al., 2005). In fact, Freeman et al. (2004) argue that
management decisions on executive incentive plans have strong implications on
7 For example, private equity funds manage approximately $1 trillion of capital (Metrick and Yasuda, 2007) 8 In the UK alone there are 35 employee and trust owned businesses, a list of these closed corporations can be found at www.jobownership.co.uk. This of course does not include firms that offer ESOPs or other similar plans. 9 Jensen and Chew (1995, p10) also argue that in general the inefficient internal corporate control mechanism is due to “the conflict between management and shareholders over control of corporate “free cash flow. “”
9
principal-agent problem as well as on the ‘moral debt’ redistribution problem by
impeding an open corporation from moving towards becoming a closed employee-owned
corporation. That is, “top executives frequently oppose profit sharing and broad-based
stock option programs because of the free rider (or 1/N) problem. The result is that many
executives and their hired gun compensation consultants get boards to approve incentive
plans that give most of the pie to themselves and other top officials…If some shared
capitalist programs and certain types of corporate cultures can actually address these
same objections, then there may be a conflict of interest for top executives to make most
of the strategic decisions on shared capitalist programs and corporate culture essentially
by themselves” (Freeman et al., 2004, p20). This is consistent with evidence that a firm’s
value decreases when management position becomes entrenched due to an increase in
management ownership (Fields and Mais, 1994; Stulz, 1988). See also Faleye (2007);
Edlin and Stiglitz (1995); Shleifer and Vishny (1989) for a more in-depth discussion on
the negative effects that management entrenchment has on an open corporation and its
shareholders.
(Bader, 1986, p71) argues that “it is our belief that democracy, including industrial
democracy, is not about concentrating power10 to an Executive, even if that Executive is
elected; in our view, it is about diffusing power and control among those who have the
right to share it.” This is also morally argued by the Christian theologian Matthew Fox
when he states “the perpetuation of ladder economics perpetuates the lack of compassion
that characterizes our aggressive culture. It puts power in the hands of a few at the
expense of the many who are, quite literally, at their “mercy”” (Fox, 1999, p191). 10 See Rajan and Zingales (1998) how power is just as important as ownership in an organization.
10
Furthermore, Rosen et al. (2005, p105) argue that “a proclamation that we’re all in this
together rings hollow if most employees don’t have much wealth at stake. It rings even
hollower if top executives, meanwhile, get enough to finance a small country.” What
these authors are telling us is that a firm’s shared ownership and incentive schemes must
justly distribute residual and ‘moral debt’ claims to all inside stakeholders not only to a
select band of top executives or managers (Guidi et al., 2007).
The question is can each firm maximize its value to society whilst maximizing its
market value? (Jensen, 2001). The only way a firm can achieve social and market value
maximization is through satisfying all three forms of justice (Exchange, Legal, and
Distributive), that is, by justly distributing to inside stakeholders11 their residual and
‘moral debt’ claims (Guidi et al., 2007). Furthermore, Bowie (1991, p178) asks the
questions “What about the stockholders? Is their relation to the firm anything more than
economic?...so long as they are genuine partners…They should be active, rather than
passive…not be holding stock in the firm merely to make money…” and he further
answers the questions with the argument that if “stockholders do not see themselves as
partners, then from a moral point of view their relation to a firm is more at an arm’s
length12 and it is the relation among managers, customers, and the employees that are
morally central.” This moral argument for more efficient use of human capital is also
argued by others (see Wilken (1982) for a full in depth discussion on this matter). As
Berle and Mears (1932) point out if shareholders are not actively involved they are in it
only for the money. In fact, more recently Jensen and Chew (1995) strongly argue for
11 See Jensen (2001) for in depth argument why stakeholder theory is incomplete and why the firm needs to consider the interests of all its stakeholders if it is to achieve social and market value maximization. 12 See Rajan (1992) on how agency costs increase with arm’s length relationships.
11
greater shareholding for individuals in the firm who are deemed to be active investors.
This is consistent with Hart and Moore’s (1990) theoretical argument that an open
corporation will increase its efficiency by moving to common ownership due to the fact
that the principals and the agents of the firm are the important active participants in that
firm’s activities.
Wilken (1982, p112) observes that “the various attempts to reform the company
have all had these objects: humanizing working relationships, freeing them from
authoritarian control, making the distribution of incomes fairer and above all bringing
justice into the matter of the control and application of company profits.” In fact,
Furubotn (1985, p31) argues what is broadly defined as “industrial democracy may offer
informational benefits that give the participatory firm some advantages the traditional
(hierarchically organized) firm does not possess.” In fact, Benelli et al. (1987, p554) cite
(Furubotn and Wiggins, 1984, p1) that under certain conditions “a reorganization
permitting labor representation on the firm’s board can overcome informational problems
and lead to Pareto-efficient solutions.” See also Ben-Ner et al. (2000) on the importance
of incentives in eliciting valuable private information from employees as well as reducing
costly distributional conflicts over quasi rent.
One of the aims of justice in a social economic system is to bring balance to the
power struggle between all stakeholders (Fox, 1999; Steiner, 1999; Schumacher, 1993;
Wilken, 1982). Pieper (1966, p76) argues that “the purpose of power is to realize justice.”
Therefore, the aim of power and justice is, in fact, in sharp conflict with the need for
12
hierarchy13 in the firm due to the realization that having protection and just distribution of
stakeholders’ rights improves participation and efficiency in the running of the firm
(Gompers et al., 2003; Steiner, 1999; Furubotn, 1985; Wilken, 1982). The alienable right
to exercise power is directly linked to the ownership of residual claims by profit-seeking
private groups i.e. shareholders, directors, employees and for example, SBC is structured
in such a way as to limit the setting-up of such self-seeking power centers based capital
or profit (Schumacher, 1993; Wilken, 1982). Reforms should not only focus on the
economic and legal forms of justice but requires a firm to distribute the ‘moral debt’
claims of inside stakeholders when making business decisions thus ensures that a firm
maximizes its value to society as well as its market value (Guidi et al., 2007; Jensen,
2001). Stiglitz (2006, p190) points out that an open organization cannot its value to
society if it “single-mindedly” maximizes its market value (profits).
With the understanding of the obligation associated with ‘moral debt’ comes the
realization that all stakeholders have a claim on a firm’s assets (Guidi et al., 2007).
Theoretically, stakeholders could hold a percentage claim towards all the securities of a
firm, i.e. its equity and debt. The scenario of holding both equity and debt will reduce the
conflict between shareholders and stakeholders on a firm’s residual cash flows (Jensen
and Meckling, JM, 1976). Therefore, stakeholders, especially inside stakeholders, may
have part of the ‘moral debt’ claim converted to equity, i.e. to common stock residual
claims, to ensure better rights protection as an investor. One advantage of conversion of
debt to equity comes from the fact that not all countries legal systems offer the same
13 See Rajan and Zingales (2001) study on how different hierarchal firm structures develop due to economic conditions.
13
protection to stakeholders compared to shareholders (Gompers et al., 2003; Stulz and
Williamson, 2003; Shleifer and Wolfenzon, 2002; La Porta et al., 2001, 1998). In fact,
Furubotn (1988, p168) argues “objectively viewed, labor’s investment in the firm can be
understood as a vital input; the capital in question represents nothing less than one part of
the total capital stock needed by the firm for production. In effect, joint investment takes
place, and workers, just as conventional stockholders, contribute to the firm’s total capital
requirements. It is arguable, then, that worker-investors should be regarded as equity
holders” (see also Alchian, 1983). Furthermore, Rooney (1991, p312) argues that a firm
engaging in profit sharing is effectively structuring itself has a “special case of employee
ownership” and thus behaving has an employee-owned firm where employees “claim to a
share in the residual is indisputable.”
3. The Theoretical Issues of the Closed Corporations
Jensen and Meckling (1979) argue that the production function of a firm impacts on
the residual risk-bearing and decision-making functions of that firm. Thus, a corporation
can be thought of as a “legal fiction that serve as a nexus for a complex set of contracts
among individuals” JM (1979, p168)14. Therefore, an individual implicitly and explicitly
enters into a set of contracts that delineates the rights and obligations of the individual in
the activities of an organization and thereby such contracts are important determinants in
effecting behavior of participants through the rules and incentives associated with a
firm’s activities. In other words, residual and decision-making rights together with
organizational structures play an important role in motivating self-interested and wealth
maximizing individual to become more efficient in productivity. The four main 14 See also Boatright (2002) and JM (1976).
14
determinants15 that are a fundamental argument against a closed corporation are (JM,
1979):
• The horizon problem: induced by the truncated (nonperpetual) claims on the
firm’s cash flows
• The common-property problem: induced by equal sharing of firm’s cash flows
among all employees
• The nontransferability problem: induced by the fact that employees’ claims on
firm’s cash flows are contingent on employment with the firm and are
nonmarketable.
• The control problem: induced by the specification of the political procedures
within the firm by which the employees arrive at decisions and control the
managers.
3.1 The solution to the horizon problem and the reduced demand for capital
JM (1979, p180) quite rightly argue that employees of a closed corporation “have
claims on cash flows that are contingent on employment.” Furthermore, they argue that
an employee wants investment decisions horizon to equal his/her retirement date
(assuming this is the termination date of employment). Therefore, the cash flows of
investment project will need to be truncated at employee termination date and so will
reduce the number of investment opportunities especially for those projects whose
15 JM (1979) have 5 determinants including the determinant of the impossibility of pure rental: induced by the necessity for any firm to acquire intangible assets that by their nature cannot be rented. This we feel is not relevant in our discussion since all closed corporations are assumed to be competing in competitive markets.
15
present value of expected cash flows would be positive after termination date. Further
still, a closed corporation employee’s wages, perquisites and bonuses are constraint by
the yearly net cash balance. Again, this will lead to employees’ endeavoring to increase
short-term cash flows of a firm. JM (1979) argue that this could lead a closed corporation
to increase borrowing leading to the cash proceeds to be paid out in current wages or
bonuses whilst leaving future employees to pay the debt.
The aim of the constitution and organizational structure of Scott Bader
Commonwealth (SBC) is to achieve consensus between managers and those that are
managed (other partners or what we would call employees) so that a high level of
motivation, job satisfaction and low staff turnover is produced (Schumacher, 1993;
Bader, 1986; Wilken, 1982). The constitution of SBC ensures that no more than 40% of
annual net profits are appropriated by the commonwealth at any one time and only half of
the appropriated profits are for the payment of bonuses to partners (Schumacher, 1993).
Thus, there seems to be a major move away from short-term individual self-interest to
more collective long-term interest. “People understand that the company, our company,
suffers if we take too much out of it. In fact, there has only been one occasion on which a
General Meeting has disagreed with recommended bonus –when they argued that it was
too high!” (Bader, 1986, p72).
The John Lewis Partnership reduces the horizon problem by offering its staff a non-
contributory pension scheme after 5 years of employment (the time delay before staff can
access the non-contributory pension scheme helps to reduce the common-property
16
problem of equal claims, see section below for full discussion on this matter). The JLP
website in the section entitled ‘Care of Partners when working and in retirement’ state
“we are committed to keeping our non-contributory pension scheme open at a cost of
£85m, in 2005-06.” Thus, the JLP non-contributory pension scheme annual payments
depend on continuous future profitability of JLP which in itself is strongly associated
with the long term prospects of the company, i.e., beyond any individual’s termination
date. Thus, JLP’s contributions to the pension scheme requires that future investment
projects, whose termination horizon be beyond the individual employee’s termination
horizon, will lead to a greater demand for capital to finance positive NPV investment
projects that will sustain and increase JLP’s value in the long term.
Furthermore, JLP’s non-contributory pension scheme supports partners in dealing
with the self-control problem during income generation (partnership) years in a similar
way as “some athletes hire agents to invest their incomes and limit their current spending,
and many of them become rich. Others rely on discretionary strategies and end up
bankrupt” (Thaler and Shefrin, 1981, p401). Thus, JLP noncontributory pension scheme
justly distributes to individual partners their residual and ‘moral debt’ claims beyond the
individual’s termination dates thus fulfilling the firm’s moral responsibility (Guidi et al.,
2007) and as a consequence, JLP ensures an income stream for individual partners in
retirement when that individual’s income generation through wages and bonuses will
decline dramatically or cease all together.
17
3.2 The solution to common-property problem
JM (1979) argue the problems associated with common-property is that new
partners will acquire equal claims on a firm’s cash flows as existing partners and that
potentially a subset of partners in a firm could ultimately make themselves better off by
decreasing the number of other partners by undertaking ‘unprofitable’ investment
projects or laying the other partners off. Schumacher (1993, p233) states how the Scott
Bader Commonwealth (SBC) innovatively deals with the common-property (equal
claims) problem; “ Mr Bader realized at once that no decisive changes could be made
without two things: first, a transformation of ownership- mere profit sharing, which he
had practiced from the very start, was not enough; and second, the voluntary acceptance
of certain self-denying ordinances…establish a constitution not only to define the
distribution of the ‘bundle of powers’ which private ownership implies, but also to
impose the following restrictions on the firm’s freedom of action…remuneration for
work within the organization shall not vary, as between the lowest paid and highest paid,
irrespective of age, sex, function or experience, beyond a range of 1:7, before tax.” The
restriction of action policy in SBC recognizes Thaler and Shefrin (TS, 1981) argument
that individuals are assumed to be both a farsighted ‘planner’ and a myopic ‘doer’ and
the resulting internal conflict is seen to be fundamentally similar to the conflict between
principal-agent of a firm. Thaler and Shefrin (1981) suggest that the solution to the short-
sighted selfish ‘doer’ problem is the same for a firm and an individual, in that, to reduce
this internal conflict two techniques need to be used: rules and incentives, which will
control and reward an individual or group of individuals depending on the behavior
(decision-making). Furthermore, the firm can adopt rules that will “eliminate discretion
18
over a specific class of decisions for which the conflict is particularly acute” (TS, 1981,
p398). Thereby, rules set in SBC’s constitution eliminates the both of the equal claims
problems by ensuring that residual, decision-making and ‘moral debt’ claims are not
unjustly redistributed to a subset of partners.
The SBC and JLP also offer incentives by the way of year end bonus. JLP in the
section ‘The Partnership Spirit’ state “profits are shared equally among Partners, and
everyone receives an equal percentage of their salary as an annual bonus – 15 per cent in
2005-06. This gives everyone in the business a shared purpose and tangible reason to
serve customers to the absolute best of their ability.” Thus, JLP has implemented the
yearly bonus scheme that eliminates the equal claims problem of JM (1979) by ensuring
payment is commensurate to job responsibility. Furthermore, TS (1981) argue that total
saving for an individual with a year end bonus will exceed that for an individual with no
year end bonus because of the technology of self-control. That is, “by paying the bonus
the firm is acting as an external self-control device” TS (1981, p401). Thus both SBC and
JLP have come up with good solutions (rules and incentives) to eliminate the common-
property problem by ensuring appropriate payment of residual and ‘moral debt’ claims to
each individual commensurate to their ‘rank’ within that firm. That is, SBC and JLP are
justly distributing both residual and ‘moral debt’ claims to partners in the firm whilst
recognizing differing job responsibilities will effect the proportion of the claims and thus
both firms recognize their moral obligation “whereby a ruler or steward gives to each
what his rank deserves” (Pieper, 1966, p83).
19
To avoid the situation whereby a subset of partners make themselves better off by
decreasing the number of other partners, the Scott Bader Commonwealth constitution
protects partners by having a rule that “…as the members of the Commonwealth are
partners and not employees, they cannot be dismissed by their co-partners for any reason
other than gross personal misconduct. They can, of course, leave voluntary at any time,
giving due notice” (Schumacher, 1993, p234). This rule in the constitution save guards
individual rights, allows for just distribution of claims, and stops abuses of power. Some
may argue that this rule in the constitution is inflexible, non wealth maximizing, and non-
Pareto optimal for a firm when, for example, the country or the world that a firm operates
in is in recession which may lead to cash flow problems and thus requires possible lay
offs (Futubotn, 1988; Nuti, 1996). In fact, in recessionary period of 1982 Scott Bader
Commonwealth found itself in such a dilemma and was still able to get agreement from
all partners to a “generous and equitable voluntary redundancy procedure…and the
subsequent working out of a clear manpower plan…” (Bader, 1986, p73).16 In other
words, Scott Bader Commonwealth was flexible in corporate form to ensure no subset of
partners could make themselves better off by decreasing the number of other partners by
involuntary means. In fact, Bai and Xu (1996) argue that in an open corporation (private)
information asymmetry yields situations where the owner wants to layoff employees
when that firm does not perform well although it is not socially efficient to do so because
the uninformed employees would not be willing to make wage concessions in bad states.
Whilst, they argue that in an employee-owned firm, however, there is less (private)
information asymmetry and hence no inefficient layoff. Bai and Xu (1996, p3) further
16 See also Wilken (1982) on the flexibility of SBC has an organization to act when economic conditions change.
20
point out that in an open corporation it is not distinguishable “between firing and layoff”
and thus an open corporation is “not able to commit not to layoff employees.” Therefore,
the action of seeking voluntary redundancy from informed partners, who have an
influence on the firm’s decision follows Pieper (1966, p96) assertion that “in distributive
justice something is given to a private individual insofar as what belongs to the whole is
due to the part… This means that the share in the bonum commune due to the individual
is “distributed” to him.” Informed voluntary agreements also satisfy the assertion made
by Guidi et al. (2007) that residual and ‘moral debt’ can only be fully repaid if an
individual gives informed consent, e.g., in the case of SBC situation a partner is fully
informed and accepts the voluntary redundancy based on full understanding on the how
his/her residual and ‘moral debt’ claims are going to be distributed to him/her through the
redundancy package.
Fox (1999) argues that unjust redistribution is achieved more readily in an open
corporation through having an unaccountable hierarchical system that abuses power. In
other words, an open corporation has more opportunity to unjustly redistribute rights and
‘moral debt’ claims to a subset of partners (shareholders, managers, employees) than a
closed corporation. In fact, (Fox, 1999, p205) cites the case of A.T. & T. who have
around one million employees in the USA which “80% of the females earn less that
$7,000 annually, while 96% of its white males earn more. The Equal Opportunity
Commission has called A.T & T. “without a doubt the largest oppressor of woman
workers in the U.S.” and clarifies his argument by stating “it is clear that the workers at
the ladder’s bottom – especially women, blacks, and Hispanics – are subsidizing the
21
continued good fortunes of that tiny elite at the ladder’s top”. Therefore, the fact that
certain business decisions of a firm involuntary and thus unjustly redistribute residual and
‘moral debt’ claims belonging to less powerful employees to a more elite subset means
that that firm ultimately increases its level of ‘moral debt’ thereby not maximizing its
value to society (Guidi et al., 2007).
3.3 The solution to the nontransferability problem: monitoring and the
efficient allocation of risk
The monitoring problem is due to the fact there is no market for the non-tradable
shares and thus no market for takeovers (corporate control) leaving the possibility for a
closed corporation to become inefficient by becoming either under- or over- valued
(Jensen, 1994, 1988). However, if employees in a closed corporation are allowed to
transfer their control and residual rights, as in an open corporation, then the benefit of
reduced agency costs may be lost (Futubotn, 1988). That is, if for example partner’s in a
closed corporation sold their residual rights to a third party (outside shareholder) then this
will lead to major agency (monitoring and bonding) costs and thus heavy discounting in
the value of the residual claims to be traded (JM, 1976). The increase in agency costs
may appear because if employee’s residual claims “were traded in the open market on a
large scale, workers with no further hope of profit sharing would have much less
incentive to avoid shirking and to perform diligently for the company” (Futubotn, 1988,
p173)17. There seems to be less shirking in a closed corporation as argued by Freeman et
al. (2004, p3) when they state “the bottom line message from our analysis is that shared
capitalist arrangements, in which firms share rewards and decision-making with workers 17 See also Stiglitz (1981).
22
and have good labor-management practices, encourage workers to act against shirking
behavior and thus to reduce the tendency to free ride that risks loss of productivity.”
Furthermore, Bai and Xu (1996) theoretically show that there is a smaller (equal)
monitoring cost and thus a lower (same) social cost in an employee-owned corporation
than in an open corporation when there is high (low) monitoring implementation required
by a corporation. Thus, the more ethical closed corporation, similar to SBC and JLP, will
maximize its value to society more than an open corporation since it will always have the
lowest social cost by possessing the most efficient common sharing of risk-bearing and
decision-making functions thereby justly distributing residual and ‘moral debt’ claims to
all inside stakeholders (Guidi et al., 2007).
JM (1979, p184) argue that the non-transferability of employees’ claims means that
employees face a serious constraint on diversifying their portfolio (see also Futubotn,
1988). The first question is how much of the employee claims are met in an open
corporation, i.e. do they get decent wages, bonuses, and non-contributory pension
schemes? Compare this to the more ethical closed corporation of SBC or JLP which
ensures employee residual and ‘moral debt’ claims are justly distributed. Jensen and
Smith (JS, 2003, p141) argue that “the common stock of open corporations allows more
efficient risk sharing among individuals than residual claims that are not separable from
other roles in the enterprise.” JS (2003, p142) do concede that “however, it does pay to
define a partial set of contingent claims such as insurance contracts, forward contracts,
and futures contracts that permit additional specialization of risk bearing. They facilitate
the shifting of risk in specified dimensions from stockholders.” In fact, Acemoglu and
23
Shimer (1999) show that for risk-averse employees a better mode of risk diversification
than tradable shares can be achieved with even partial level of unemployment insurance
which creates more efficient risk-bearing and also increases employee productivity in a
firm.
Partners in SBC and JLP are better off than most employees in an open corporation
due to the fact that they have a fair share in the residual claims of the firm whilst
employees in an open corporation do not. In the case of JLP they also receive future cash
flows at termination via the non-contributory pension scheme which diversifies the
partners’ personal portfolio cash flows. Also, with more extensive range of risk bearing
markets now available in developed countries, e.g. insurance markets, bond markets and
other securitization markets, partners can decrease the project contribution to their
personal portfolio i.e. increase diversification by spreading the risk due to the non-
tradability of their equity in a closed corporation just as well as employees in an open
corporation with diversified private pensions/portfolios. This is acknowledged by Fama
and Jensen (1985, p217) when they point out that “we can, however, construct situations
in which proprietorships invest more than open corporations with the same investment
opportunities. For example, suppose technological trade-offs make it possible for a
proprietor to reduce the variance of her undiversified portfolio return by moving to more
capital-intensive production procedure. Reducing variance that arises because of lack of
diversification may then cause the proprietor to undertake more investment than an open
corporation that follows the market value rule.” In fact, SBC constitution states that a
24
minimum of sixty percent of the annual net profits must be retained for reinvestment and
taxation (Schumacher, 1993).
3.4 The solution to the control issue
The control problem is induced by the specification of the political procedures
within a firm by which the workers arrive at decisions and control the managers. In an
open corporation the hierarchical management structure is an important mechanism in
monitoring because external market competition for management positions (Fama, 1980;
Brickley et al., 2002). However, Stiglitz (1981, p248) argues that “the market provides
only weak instruments for ensuring that inefficient managers (“controllers of capital”) are
replaced by efficient managers, particularly in widely held firms. For the usual reasons
(“free rider” problems, costly information)…” See also Grossman and Hart (1980) on
reasons why there are limited efficiency gains from capital market takeover mechanism.
In fact, Stiglitz (1981, p249) argues that there is poor monitoring by outside shareholders
in “that control over the managers of firms is not exercised so much by the share-holders,
the suppliers of equity (although they nominally have “voting rights,” these are not very
effective), as by the lenders, who are in a position to withdraw their capital if the firm
“misbehaves.”” In other words, outside shareholders have limited indirect and imperfect
exercisable control over the use of the firm’s capital and thus limited effect in ensuring
efficient management. Gadhoum et al. (2005, p360) argue that the market and
institutional response in monitoring managers is limited and thus the argument for
leveraged buyout to resolve the problem “simply ends the separation of ownership from
25
control”. That is, advocates of LBOs in capital markets are suggesting that an open
corporation should change to a closed corporation.
Bader (1986, p70) argues that “participation in decision-making and co-
determination are possible in all enterprises, irrespective of who the owners are.
Democracy, however, is only possible when the members themselves, and they alone, are
ultimately responsible for the control of the resources of the enterprise” (see also Rosen
et al., 2005; Steiner, 1999; Futubotn, 1988; Wilken, 1982). In other word, employee and
stockholders interest become aligned due to the fact that employees (decision-makers) are
the stockholders (residual rights claimants) thus reducing conflicts of interest due to goal
congruence (Furubotn, 1985). Thereby employee-ownership that recognizes
alienable/inalienable rights of inside stakeholders through a democratic ethical closed
corporation, which by its nature will allocate more efficiently the risk-bearing and the
decision-making functions, will ultimately increase the firm’s value to all inside
stakeholders and thus maximize its value to society better than an open corporation.
26
4. Conclusion
It is generally agreed in academic finance literature that the open corporation with
its separate residual risk-bearing and decision making functions survives because it
delivers product and services demanded by consumers at the lowest price (see Fama and
Jensen, 1983a, 1983b; Jensen, 1985). This point of view is becoming less acceptable; in
fact, it is argued that open corporations may have outlived their usefulness in many
sectors of the USA economy (Jensen, 1989).
Nowadays there seems to be a thriving market for closed corporations such as
private equity firms as well as other more ethical responsible corporations like Scott
Bader Commonwealth and John Lewis Partnership. One of the main reasons that there is
a thriving market for closed corporations is due to the closed corporation having
substantively lower agency costs whereas open corporation by its nature has major
conflicts of interest (Jensen, 2001; Jensen and Chew, 1995; Jensen, 1989; Jensen and
Meckling, 1976). The less inherent conflict of interests in a closed corporation is due to
the corporation allowing sharing of risk bearing and decision-making functions. Which in
fact many open corporations are endeavoring to simulate so that they too can diminish
the conflicts of interests and their associated agency costs by providing equity ownership
in the form of ESOPs or other similar schemes to inside stakeholders (see for example
Chang and Mayers, 1992; Rooney, 1991; Morck et al., 1988; Demsetz and Lehn, 1985)
This paper argues that the more ethical closed corporations, like SBC and JLP, will
maximize their value to society more than an open corporation (including private equity
27
firms) since they always have the lowest social cost through allowing sharing of risk
bearing and decision functions to inside stakeholders and by also justly distributing
residual and ‘moral debt’ claims to all inside stakeholders (Guidi et al., 2007). With the
realization that the firm has ‘moral debt’ comes the realization that all inside stakeholders
have a claim on the firm’s assets (Guidi et al., 2007; Rooney, 1991; Furubotn, 1988;
Alchian, 1983).
28
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