Shareholder Primacy

Shareholder Primacy

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Bad and Not so Bad Arguments for Shareholder Primacy

In the Introduction of the article of the author Lynn A. Stout pointed out the two arguments in regard to shareholder primacy that were made by Adolph A. Berle and Merrick Dodd.

Adolph A. Berle argued for “Shareholder Primacy” in that he believed that the corporation exists only to make money for its shareholders.
Merrick Dodd argued against it his view was “the business corporation as an economic institution which has a social service as well as a profit making function”.
Although both men have argued over this the result of what the interest of the business lie in still remains unsolved.
No one can be sure if the firm exists to increase shareholders wealth or to serve the interests of the stakeholders of the business. Yet there has been no more research has been done after the debate to solve the argument.

Therefore from this I can interpret that the argument is whether the interest in the business lies in the interest of the shareholders or stakeholders.

So then the author Lynn A. Stout goes on to list the arguments for and against these theories –

1. The Shareholder Ownership Argument for Shareholder Primacy.

In this argument the Author considers the most common argument which is that the Business “belongs” to its shareholders in that its main purpose to increase shareholder wealth. While shareholders do not own all of the business the do own a stake in it so for this their rights as “the owners” are quite limited this is where the Agency theory takes effect while shareholders are seen as the owners they do not manage the day to day running of the business that managers do. Shareholders do not receive a salary or wage like managers but rather receive a dividend which only can be received if the directors declare one. So my interpretation is that shareholders no not have any right of control over the firm’s assets. Then Lynn A. Stout goes on to talk about Fischer Black and Myron Scholes famous paper which looks at the options theory from this I can presume that its theory is that is the company is in debt the debtholders have the right to the companies cash where as the shareholders don’t.
So the theory behind the whole argument is that while the shareholders are involved in the Business they simply do not own the business.

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2. The Residual Claimants Argument for Shareholder Primacy.

The second Argument the Author considers the fact that while the shareholders do not own the business they do have a stake in it meaning they have a claim to it. It then looks in to the theory behind this argument in the work of Frank Easterbrook and Daniel Fischel who conclude that the business is a contract between its Shareholders and Stakeholders, which again suggests Agency theory to me that while the Shareholders invest their money in the business the Managers run it to provide a service or good that its customers buy which inturn makes the profit for its shareholders. Therefore one can conclude that Stakeholders are entitled to fixed payments e.g. Wages and Salaries while Shareholders are entitled to receive dividends after the fixed payments have been made.
The Argument points out that Shareholders are infact the “Residual Claimants” as they took the risk to invest their capital in the business in return for a dividend. So therefore the theory that the interest in the business is to increase shareholder wealth is some what correct but the theory that they own the business and are entitled to everything it earns is incorrect.
Then it is pointed out that the only time the Shareholders are the Residual Claimants is when the business is actually in bankruptcy and that Shareholders will only received a dividend when two conditions are met theses are –

• The business must be doing well enough financially to permit the directors to declare a dividend.
• The directors must actually decide to declare a dividend.

These two points I believe to mean that if the business id financial stable then the directors can decide to pay out a dividend or to plough more money back into the business. More often when a businesses balance sheet or earnings statement permits they often choose not to pay it out. This is mainly because if the business boosts stock prices then this inturn increases share prices which keeps the shareholders happy. So therefore I can interpret from this that it’s either small dividend payouts or nothing at all.

Then it can often be seen from a shareholders perspective that Directors are serving the Stakeholders first and the shareholders second, so then they try to sell their shares and then the shares can often be of little value or instead of selling their shares they can go to the board and try and remove them, if they choose to take this road they have very little limited ability to do so. So all the shareholders can pray for is a takeover bidder but this can work out to be very expensive and uncertain.

Its not all bad for shareholders, sure they suffer when times are bad but when times are good the receive the benefits. Basically they Share the Success and Share the Loss with the Business.

So to conclude this argument it is said that if Shareholders are not the Residual Claimants they ought to be. But why should they be? There is still no solved answer to support this.

3. The Team Production Argument Against Shareholder Primacy

This argument questions that while shareholders invest their capital into the company it simply is not good enough for the business to survive. It needs inputs from various stakeholders to be successful and to provide the shareholders with their dividend. For example we need employees to provide the good or service in return for payment and we need customers to buy the good or service.
So it’s a two way street Both Shareholders and Stakeholder are extremely important to the success of the business.

Like Shareholders, Stakeholders have expectations of the business for example job security and the prospect of promotion.
Stakeholders like employees believe that if they work hard enough they will reap the benefits from the business in a nonformal contract. So it is in the interest of the shareholders to help these expectation to become reality so that they make a gain because if employees work harder means a better service to customers etc. which means an increase in profit.
So if the Directors where to focus entirely on the Shareholders then the Stakeholder wouldn’t feel respected and then there wouldn’t be motivated staff so no increase in profits.
As illustrated in Strines Hypothetical if the firm is sold to the highest bidder Shareholders will benefit while Stakeholders will suffer with layoffs etc. but on the other hand if the firm sells for a lower price then both shareholders and stakeholders will benefit as there wouldn’t be any layoffs for the stakeholders. It means more to stakeholders that they are respected enough by the directors.

So to conclude this argument I can interpret that Directors need to maximise their profits but in order to do this they must serve their Stakeholders with the same respect as they do their shareholders, and often no dividend is paid out to protect the stakeholder. This is where director primacy takes effect meaning that Directors must either serve Shareholders or Stakeholders to maximise profits.

4. Counterbalancing Team Production Concerns: The Agency Cost Argument for Shareholder Primacy.

So this Argument is seen as the best argument for shareholder primacy. From what I gather it is said that Directors are seen as Agents and that Directors try to balance both interests of shareholders and stakeholders, but the world isn’t perfect and people take advantage of their position and look after their own interests. So directors try to do what is best and hassle free for them e.g. The Dcc Man who sold his shares after the profit warning.
So this Agency costs come into place, these costs can be measured by monitoring and measuring an agent’s performance. So the question is how can the agent’s performance be monitored and measured?
Share Price is a great way to measure and monitor the agent’s performance where a measure of stakeholder happiness is simply not enough! So the debate still is unsolved as to whether the director should serve its Shareholders or Stakeholders. It is also noted that in the interests of all parties Shareholder Primacy is very important and is referred to as the second best solution for all parties of the business.

But still the question cannot be answered if the interest of the business should lie in the interests of the Shareholders or Stake holders.

5. Some Empirical Evidence: Which Rule Do Law Makers, Managers And Shareholders Actually Choose?

There is no actual definitive answer to this question!!!

The only people that can decide what option is better lies in the hands of the executives, Directors and shareholders and employees who are all involved in the business on a daily basis and the there are people as Strine points out “who are faced with the necessity of choosing between strategies and rules that favour Shareholders, and strategies and rules that favour a broader range of corporate constituencies”.
So what I gather is that people involved with the business must make important decisions and live with the consequences if they choose the wrong ones and that Directors often get face hard decisions when choosing between Shareholders and Stakeholders and this is how Director Primacy is more favoured.
When Stakeholders are put first directors redirect wealth from shareholders which makes the stakeholders happier but the shareholders less happy. So technically they are sacrificing shareholders interests to serve the stakeholders.
It is also said that business that do not serve the interests of the Shareholder are more successful than firms that do.

To conclude this I gather that nobody can decide which option is more successful to the business as nobody can prove that Shareholder Primacy is efficient or inefficient.
Therefore nobody can decide who is to be served until the efficiency or success can be proved.
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