Yet more on fiduciary obligation

by John Quiggin on July 31, 2008

I’m planning a further post about the notion of ‘creative capitalism’, but before I get on to it, I thought it might be useful to clear up some of the confusion surrounding the alternative view, that managers have a ‘fiduciary obligation’ to act solely in the interests of shareholders, reflected in debate at my blog, at CT here (including this and here) and at the Creative Capitalism blog.

A surprising number of people seemed to want to argue that, even in the absence of any legal enforceable obligation, and therefore any reasonable ex ante expectation on the part of investors, managers are morally obliged to put the interests of shareholders before their own, and before the interests of any other stakeholders. This ethical absolutism is particularly odd when it is combined with a willingess to endorse breaches of implicit contracts with workers and, as in Richard Posner’s post, hypocritical pretences of corporate altruism.

This kind of claim about the moral responsibility of managers as agents runs against the whole body of literature on principal-agent relationships, which takes a starting point the assumption that agents will pursue their own objectives within the constraints of their contractual relationship with the principal. It’s up to the principal to design the contract in a way that aligns the interests of principal and agent (this is called incentive-compatibility).

The other point raised by Daniel is that the concept of maximizing profits is too ill-defined to act as a real constraint on managers. Hence, if fiduciary obligation is to made an implementable policy, it must be tied to something more concrete.

There is one coherent version of fiduciary obligation that satisfies the incentive compatibility requirement. This is the view that managers are obligated to seek the maximum possible increase in the stock price (after taking account of dividend payments), and that they should be motivated to do so by being paid largely or wholly in stocks or options. This is consistent with fiduciary obligation if the shareholders are taken to be the specific group who hold shares when the manager is appointed, and whose interests are therefore aligned with the manager’s. Finally, stockholders can use lawsuits to protect themselves against opportunistic manipulation of stock prices.

This approach was highly popular during the 1990s, but the dotcom boom in particular showed its weaknesses. On the one hand, it turned out that stock price manipulation was easy to do and hard to prove, while the remedy of stockholder lawsuits came to be seen as a cure worse than the disease. On the other hand, as the principal-agent literature predicts, risk-averse managers don’t want their entire return tied to the vagaries of a stock price. So, they’ve not only sought to write contracts that guarantee them a large risk-free income, but they rewritten those contracts ex post when the terms called for them to share the losses of stockholders.

So, the idea of managers as agents who share the interests of stockholder-principals is problematic, and the idea of managers as capitalist saints who subordinate their own interests and objectives to those of an abstract body of stockholders is nonsensical. That doesn’t provide a positive basis for any alternative corporate objective to the pursuit of profit (including rents captured by managers) in some form or another. I’ll come to this point, I hope, in my next post.

{ 28 comments }

1

Steve Laniel 07.31.08 at 3:05 am

As a friend pointed out when I shared Daniel’s post with him the other day: really engaging with this issue would require everyone to look at cases where executives have been sued over their failure to meet their fiduciary obligations, and have lost. A convincing argument here would require a coherent explanation of what binds together the losing cases. If Daniel is right, wouldn’t losing executives have to be *reeeeeally* egregious in their self-dealing?

2

John Quiggin 07.31.08 at 3:56 am

A relevant article here (mainly concerned with whether enterprises in areas like health can pursue social objectives after privatization/conversion to for-profit status)

http://findarticles.com/p/articles/mi_qa3655/is_200204/ai_n9029086

a review of the current status of the for-profit director’s duties reveals that the social entity model of the corporation governs most of a director’s decision-making. This means that corporate law allows directors of post-conversion companies to take actions that advance the interests of their beneficiaries, even when those actions fail to generate the maximum level of shareholder profit. Hence, opponents of privatization are laboring under a misconception about the aims of the corporation, and to the extent that they base their objections to privatization on this misconception, their objections do not have much force. Moreover, there is empirical evidence to support the notion that, in practice, directors of postconversion corporations have behaved in a manner consistent with the social entity model of the corporation. This evidence, buttressed by the current status of corporate law, undercuts the force of the philosophical objection to privatization. It also suggests that the social entity model may have taken center stage in our conception of the corporation.

3

abb1 07.31.08 at 6:24 am

One thing I don’t think anyone mentioned in the comments to these posts is that talking about shareholders/stockholders as a homogeneous group is misleading.

There are a few real stockholders – capitalists (people and entities) who own tens of millions dollars worth of stock – and then there are tens of millions of patsies like you and me who own a few shares. The fact that the managers (who are themselves capitalists too) don’t represent interests of the patsies is not at all surprising; feature, not a bug. We are but sheep to be shorn, and eaten.

4

Lindsay 07.31.08 at 8:23 am

There is a further problem with the stock option model, though it may be implicit in John’s remark that “risk-averse managers don’t want their entire return tied to the vagaries of a stock price.”

Most shareholders (read “pension funds and other institutional investors”) do not want to maximise their return on their holding in a particular company; rather they want to maximise their returns over their entire portfolio. The difference is subtle, but it has the important consequence that shareholder principals will want their agent managers to take amore risky approach than will the managers. Shareholders will tend to manage that risk by diversifying their holdings accross a broad range of investments, whereas agents rewarded in terms of stock options have a high proportion of their wealth tied up in the future value of one investment, and might be expected to prefer a relatively more cautious approach. Another nail in the coffin for the “maximise the present value of future performance” theory.

5

Tracy W 07.31.08 at 8:41 am

Another view of fidicurary obligation is that the shareholders should write the contract with their managers with the intent of providing incentives for the manager to maximise profits, and shareholders should seek to hire managers who have in the past displayed efforts to maximise profits for them or for other shareholders.

Of course any particular contract, or idea for writing contracts, may fail. And any particular manager may suddenly start behaving radically differently (brain tumours being merely one cause of behavioural changes).

But on the whole, the continued success of sharemarkets as venues for investors makes me think that despite all the messiness of life shareholders, even shareholders in public companies, do manage to find managers who increase profits.

Perhaps John Quiggin would be happier if we changed the question of fidicurary duty as to whether shareholders should seek managers who maximise profits, or if they have a moral obligation to seek managers who pursue broad social goals.

6

bad Jim 07.31.08 at 9:27 am

Executives with short time horizons striving to pump up the stock price from quarter to quarter are in perfect synchrony with identically incentivized institutional investors, but challenge the theory of the profit-maximizing firm so dear to conventional economic theory.

When I was in the game, my partners and I tended to be attentive to profitability, cash flow, and the putative well-being of all of our stakeholders, customers as well as employees and shareholders. We were however playing a long game with our eye on the ultimate paycheck, the liquidity event, and perhaps our attention to the health of the firm was no more than window-dressing. But it wasn’t. We (and by “we” I mean the people who were actually involved in the dirty details; I was never urgently called into action until a toilet overflowed or a lawsuit arrived or the bank curtailed our credit) acted as though we meant to keep the company going forever, as though profit was more important than price.

Whenever we had a profitable quarter we divided a portion with the employees. (Hours huddled in a small office contemplating a spreadsheet debating weighting factors. “We need to add another column.” Another hour lost.)

A small firm ($30M, 100 workers) of our sort is not a sustainable option, perhaps. We have finite lifetimes, and by the end one of my partners wouldn’t even talk to me. The enterprise lasted ten years from founding to sale, a bit longer than the average tenure of big-firm star-quality management. I can’t quite complain that the firm that bought ours erased its value when it closed our factory, since I’d already cashed my check, but I’m inclined to think that more money could have been made if they’d kept it running.

Our quaint little company manufactured things, which isn’t done anymore in this country. The subcontractors are gone. My brother-in-law now gets injection-molded prototype parts from China faster than we used to get them from the tool-maker up the street.

Maybe the only game left is to take the money and run. Va, bene. I got mine.

7

bad Jim 07.31.08 at 9:39 am

To clarify: first articles from China before prototypes from neighbor, and we never could afford injection molding (cheap parts but impossible capital investment). China, now, makes previously impossibly cheap manufacturing easy. I’m not sure why this makes me angry, apart from its invalidating half the premises of my professional career. Hey! I can look forward to living long enough to see the rest of it tossed on the dustheap of history!

8

aaron_m 07.31.08 at 9:55 am

It is really not clear to me what I am supposed to be getting out of this post. Here is my confusion:

“This kind of claim about the moral responsibility of managers as agents runs against the whole body of literature on principal-agent relationships, which takes a starting point the assumption that agents will pursue their own objectives within the constraints of their contractual relationship with the principal.”

1) This claim fails on the fact/value distinction. The fact that empirically agents tend to pursue their own objects cannot on its own demonstrate that this is morally justifiable or that normative demands on agents that run counter to their interests are not justified.

2) This entire post seems to be advancing the view that the normative demands one can place on how corporations are operated should be founded along some criteria of fairness in balancing the preferences of stockholders and managers (maybe even workers lets hope). Such a view would lead to an extremely narrow and surely morally abhorrent set of normative demands.

More generally and as I noted in response to Daniel’s post it is not at all clear how it is thought that we can get from simple empirical measurement of what owners and managers want or how they act to ‘positive moral bases for alternative corporate objective to the pursuit of profit.’ Of course one could try and argue that what owners and managers want or do ought to dictate the objectives of corporations, but that principled position does not simply follow from facts about what owners and managers want or how they act.

9

aaron_m 07.31.08 at 9:57 am

I meant to write objectives and not objects

10

Sam C 07.31.08 at 11:07 am

Tracy W’s suggestion that a better question would be about what duties shareholders have when seeking managers seems half right to me. The question should be what duties people (managers, workers, shareholders, customers…) have with respect to institutions they’re involved in. A simple answer is: they should seek to create and support institutions which maximise welfare, impartially considered (I’m a philosopher, not an economist or a lawyer: I can’t help it). The question is then: which institutions are those? Creative capitalism might be a good answer to that question. But debates about what legal obligations managers currently have (in which legal system?) are a red herring, and assertions about mysteriously-grounded absolute duties beg the question.

11

Ano 07.31.08 at 1:23 pm

The other point raised by Daniel is that the concept of maximizing profits is too ill-defined to act as a real constraint on managers. Hence, if fiduciary obligation is to made an implementable policy, it must be tied to something more concrete.

I don’t think this works. This is like saying “we don’t really know how to reduce poverty, so that shouldn’t be one of our goals.” The “fiduciary responsibility” thing is about doing things that most people agree amounts to trying to maximise the present value of future profits.

12

CJColucci 07.31.08 at 2:11 pm

My own take on all this is that people should, for the most part, stick to their knitting and do what they know how to do. Business enterprises exist, primarily, to make money for their owners, who may prefer a long-term or a short-term focus and can buy or sell shares in companies that, they think, share their preferred focus. That’s what they are, in theory, good at. The shareholder, however, buys and sells in a climate of expectations where enterprises primarily devoted to making them richer are considered free to divert some of the corporate resources to the betterment of the community, either out of general altruism or out of some theory thsat, in the end, it will redound to the owners’ benefit. In such a climate of expectations, the enterprise violates no “duty” by diverting some of its resources to community betterment that does not pass some contrived long-term cost-benefit analysis. On the other hand, I see no prospect of business enterprises diverting enough resources to non-business ends to make a dramatic improvement in the community at large or to take a serious bite out of its long-term profits.

13

Eli Rabett 07.31.08 at 2:21 pm

It is really simple, if corporations exist only to increase shareholder value, limited liability should be eliminated. If the shareholders are the only ones whose interests are to be taken into account they should bear full responsibility.

14

Ambrose 07.31.08 at 3:00 pm

Abstract definitions of the purpose of corporations are close to meaningless. If one stockholder owns or controls, the corporation then the purpose is to do what he or she wants it to do. A corporation is an artificial creature of the state. The only restraints on the actions of a corporation are those imposed by law or contract. It is meaningless to apply morality to a corporation. How would you determine what set of moral values should govern its actions? Minority shareholders have no mechanism to express their values. Corporations have proved useful to assenble capital to perform an activity. The attractive thing about a corporation is that the shareholder is generally not liable for the corporations debts. It also has, practically, an unlimited life. As a society we can by our laws determine the purposes of a corporation. We can require it to make contributions to the general welfare, taxes. My preference would be not to require corporations to perform activities for the general welfare of the society since the social controls on a corporations activities as so weak. As imperfect as out government can be we can exercise a great deal more control over the actions of the government, than a minority shareholder can exercise over a corporation. Creative capitalism implies the existance of corporate managers and their duties and obligations. Capitalism does not require corporations. Individuals with sufficient funds can and do function as managers of their own personal capital. Corporations just allow the assembly of capital for large industrial or financial enterprises. States can also organize large enterprises that serve the same purposes. For purpose of analysis it might be better to think of corporations as agents of the state that have certain rights and privileges, than as people who have moral values. The contract analysis is of little value since the minority shareholder does not have a practical method to enforce any contract rights, express or implied.

15

Alex R 07.31.08 at 3:38 pm

I’m glad that several of the commenters, starting with Tracy W, have raised the issue of the moral obligations of the *owners* of the corporation — in principle, the shareholders — in addition to the moral obligations of the managers. Given that the managers are the primary agents of the shareholders, it seems clear that those moral obligations are transferred to the managers. In other words, the owners are not able to erase their moral obligations simply by hiring managers to run the corporation on their behalf.

If the managers of the corporation fail to pay attention to the interests of the community, to other stakeholders, and other similar moral obligations, they are failing to fulfill the moral obligations of the owners which, as their agents, it is now their responsibility to fulfill.

16

seth edenbaum 07.31.08 at 4:14 pm

Bleed the pig, or kill it?
If someone takes over a company with a strategy of running up the stock price and then dumping it, making a pile for himself and the shareholders, there are limits on what unhappy campers could do.

The issue is not one of “creative capitalism,” a grotesque misnomer, but on more amorphous notions of social obligation. How one would discourage people from thinking in such limited terms should be seen as is a moral issue but from there as a societal issue not strictly as a legal one.
Laws and Social Contracts are by definition non-conflicting and are inadequate as terms of description. Better, more precise (not less) to use the language of social obligations, seen as overlapping and in conflict and need to be understood as such. These problems should be dealt with at that level. Social life is not Aristotelian.
Dream less. Observe and describe.

17

MQ 07.31.08 at 4:30 pm

Business enterprises exist, primarily, to make money for their owners, who may prefer a long-term or a short-term focus and can buy or sell shares in companies that, they think, share their preferred focus. That’s what they are, in theory, good at.

So companies exist to make money and not to make and market good products to their customers? Which would you rather invest in: a company that saw its primary purpose as making money, or a company that saw its purpose as creating a good value proposition for its customers that also allowed a reasonable return to the company and its workers? I suspect the second company would be a better long-term bet.

Also, Ambrose in comment 12 is quite correct.

18

lemuel pitkin 07.31.08 at 5:08 pm

the concept of maximizing profits is too ill-defined to act as a real constraint on managers.

Then how do profits end up being equal to the marginal product of capital? What mechanism, other than profit-maximizing by managers, is supposed to bring this about?

19

CJColucci 07.31.08 at 7:39 pm

MQ:
Why does someone spend time and effort making and marketing any products, be they good or bad, in the first place? Hint: it’s to make money. There’s a reason we call it “work,” after all. That said, your hypothetical company that creates a “good value proposition” for customers while behaving decently to the community and the workers does, indeed, sound like a better long-term bet to me. Making money does not necessarily imply cutting corners and grabbing the maximum short-term payoff.

20

abb1 07.31.08 at 7:58 pm

Company that creates a good value will soon – very soon – be beaten by someone like Microsoft. There is no future, no money in creating good value. Remember, young man: buy low and sell high, buy low and sell high – that’s all there is to it. Don’t be so naive.

21

robertdfeinman 07.31.08 at 8:18 pm

Corporations are creatures of the state and can be mandated to do whatever the enabling legislation specifies. We have examples of different models before us when we examine the laws governing firms in places like France, Germany and Scandinavia.

In the US, libertarians, like Posner, have taken a catch phrase “maximize profits” to an extreme, just as they do in other cases (individual liberty, government regulation). So they pursue an intellectually dishonest game of fostering a utopian system on the public while ignoring the realities. Enough people seem to be fooled often enough that they become champions of policies that will harm themselves personally. This is an amazing feat of intellectual misdirection, which is usually confined to promises about the hereafter.

To give some concrete examples: firms can be required to include labor in their management (Germany), they can be required to set aside a fixed amount for benefits and even to place it in an arms-length entity; they can be required to clean up after themselves by paying into a fund that will exist after they have ceased to operate.

Then there are non-profit firms, some of which even make stuff, like Paul Newman’s food enterprise. In his case the “profit” goes to charity, in the case of the Ford Foundation their “profit” (from their endowment) goes to the projects they fund. Such foundations are required by law to disburse a minimum amount of their wealth each year to maintain their tax exempt status, but if they were solely interested in maximizing their “profit” over the long term they would prefer not to. This is the situation with some college endowments at present, they have ignored the reason they were set up to begin with and are acting like for-profit firms. So the Ford Foundation is choosing not to maximize their “profit” while Harvard is.

The second dishonest argument from Posner is to ignore how things really work. There are no examples of firms with more than a few shareholders where these “owners” have any say in the operation of the firm. Proxy votes are a fiction, and boards of directors are self perpetuating. This is true in every developed country and we must, therefore, take it as an unanticipated result of modern capitalism. Since this is true, any governance claims which are allegedly to benefit the stockholders are false. Denying this is a form of intellectual dishonesty.

So, given the reality, the issue becomes a moral one, what does society want for-profit firms to do? Whatever this is, it has to be combined with legal constraints which work and force the firms to confirm to the goals. It is clear that pushing up the stock price for the benefit of option holders does not match the nominal mandate that current law ostensibly demands.

Maybe legal scholars have the luxury of debating theoretical systems, but we in the real world need some practical fixes to what is broken and Posner isn’t offering any.

22

abb1 07.31.08 at 9:31 pm

Society is the aggregate of individuals and institutions – including, incidentally, corporations and their plentiful and powerful minions (managers, lobbyists, politicians, the media, etc). What does society want? WYSIWYG; whatever you see around you is what this particular society wants.

23

Roy Belmont 07.31.08 at 10:39 pm

To add to RobtDFeinman’s “concrete examples”:
They can be made responsible for their products from manufacture to rubbish tip. So that the burdens of toxicity rest on those who create them.

#14: It is meaningless to apply morality to a corporation. How would you determine what set of moral values should govern its actions?

The same way individuals have their actions governed by sets of moral values. Law and custom. Why is that not obvious? Corporations are the ultimate sociopathic entities. People who can only recognize morality as an external force are held in moral check by the strength of that force and its willingness to govern their behavior. What’s lost in this age is morality precedes the regulation.
It originates somewhere less available to chopping logic, more emotional than rational, thus bewildering people whose only engagement with life is mechanical.

#10 The question should be what duties people (managers, workers, shareholders, customers…) have with respect to institutions they’re involved in.

Why not the same they have to their neighborhoods, communities etc? Why not the same they have to everything?
If the answer to that is they don’t have any, better make sure your bunker is well-stocked.
The human co-operative drive is far more need than notion.
Being a moral person is not synonymous with not breaking the law. It can be the diametric opposite, sometimes.
Greenpeace, for instance.

24

lemuel pitkin 08.01.08 at 2:22 pm

I’d still like to know how John Q. reconciles the skepticism of this post with the much stricter assumptions about profit-maximizing of his economic work.

25

Sam C 08.01.08 at 2:54 pm

Roy Belmont, in response to me at 10 you wrote:

Why not the [duties] they have to their neighborhoods, communities etc? Why not the same they have to everything?

Why not, indeed?

If the answer to that is they don’t have any, better make sure your bunker is well-stocked.

Why on earth would that be the answer?

Being a moral person is not synonymous with not breaking the law

I agree. Why would you expect me not to? My points were:

(1) that we need a way of justifying and criticising claims about obligations. My pick is consequentialism: obligations, rights, laws, institutions, etc. are convenient inventions, justified to the extent that they promote impartial welfare. If they don’t do that, they’re not justified – which is why being a moral person is not synonymous with not breaking the law.

(2) that it’s not only managers or only shareholders who have obligations within another of our convenient inventions, the limited-liability company. What we need to think about is the consequences of organising ourselves this way rather than some other way.

I have the feeling that you rather misunderstood me. When I asked what duties people have with respect to institutions they’re involved in, did you perhaps think I meant what duties people have to the institutions they’re involved in? I meant something much wider: given that I have some power (e.g. by being a shareholder), how should I use it? To influence the company to pursue profit, or to influence it to do something else?

26

Roy Belmont 08.01.08 at 9:40 pm

No misunderstanding, agreement. I was lecturing the hall, using your phrases as rhetorical embarkation points.

27

Sam C 08.02.08 at 10:14 am

Ah, the misunderstanding is mine: sorry.

28

John Quiggin 08.02.08 at 10:30 am

Lemuel (#18 and #24), the post you link to includes the observation (wrt the neoclassical result equality of returns and marginal product) “There are all sorts of problems with this result, and particularly with simple-minded applications of it, which are legion. ”

The principal-agent problem is a well known example, and I’ve written a number of papers on it, as well as several chapters in the book that’s linked on CT. In the presence of principal-agent problems (such as that between shareholders and managers) factor returns will often deviate from marginal product.

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