The Development of the Corporate Firm In Chapter 1, we defined the firm as a network of entities that come together for mutual profit. While that makes sense, it is not a practical prescription for how to run the firm from on day to the next. After all, firms arent run as a committee with decisions being taken ointly by all the stakeholders. !ow different firms are run differently. "he corner, independently owned, owner#operated drugstore would certainly not ha$e the same organi%ational and decision#making structure as a large corporation. While small firms are important in the &' economy, ne$ertheless, for the most part, corporations account for the greatest share of the $alue of the &' economy. (ence it makes sense to look at how corporations operate. At one time, all businesses were owned and operated, either as sole proprietorships or partnerships. (owe$er, as the &' economy de$eloped, the optimal si%e of a business enterprise also increased. "his led to a maor problem ) a single indi$idual normally did not ha$e enough resources to operate a large firm. Conse*uently, it was necessary to ha$e many people in$est in a single firm. (owe$er, as the scale of the firm grew, the number of people who had ointly contributed the capital necessary to run the firm, ## the number of owners ) got so large that it was necessary to separate management from ownership. "he other ad$antage of separating management from ownership was that if one of the owners of the firm wanted to pull out, he could sell to a second party who was willing to take o$er the ownership stake of the first party. 'ince management and ownership were separated at this point, it didnt make any difference to the running of the firm that part of the ownership shares of the firm had switched hands. (owe$er, this created another problem. Indi$iduals, such as suppliers, who had claims on the firm, knew that if the business was not generating enough cashflow to pay them back, they could go after the personal assets of the owners. 'o they certainly wouldnt be happy about ha$ing an ownership share transferred from a wealthier owner to a less wealthy owner. "he limited#liability oint#stock company or corporation de$eloped as an answer to this problem. &nder the new law, a corporation had a legal status, separate from those indi$iduals, who had contributed to its capital. Indi$iduals who had claims on an incorporated firm only had a claim on the assets of the corporation+ they had no claim on other assets owned by those who had contributed capital to the corporation. While this did not pro$ide greater security to the firms creditors, it did ha$e the ad$antage that the nature of the creditors claims was independent of the identity of those who contributed to the firms capital. A Market for Ownerhip !hare in Corporation ,nce there was no bar to the firms owners selling part or all of their stakes, it was natural that there would de$elop markets for trading these stakes. "his is what we call the stock market, i.e. stock exchanges like the !ew -ork 'tock .xchange and the !A'/A0. "he de$elopment of a market for owners shares in corporations increased the li*uidity of these shares, and, in turn, drew more capital into the corporate business sector. In todays world, indi$iduals can buy shares in a firm at the beginning of the day and sell them, half an hour later. 'uch holders of firms ownership shares are called shareholders. A transaction where a shareholder sells some or all of his stock to another intending shareholder is simply a side#deal between indi$idual parties and does not, in any way, affect the operation of the firm. With such an organi%ational structure, the corporate business sector has grown rapidly o$er time. In a corporation, typically, management is separated from ownership ) the management of the firm is pro$ided by those who are most skilled in that function, while capital is contributed by those who ha$e excess resources to in$est. (owe$er, this creates its own problems. Who is to super$ise the managers1 And what should be the obecti$es dri$ing the managers1 ,f course, e$en in a sole proprietorship, the owner has to super$ise their employees and make sure that the employees act in a way that maximi%es his2her wealth. (owe$er, in the case of a corporation, there are no 3owners4 who are around to super$ise managers+ as we saw before, ownership of a corporation could be a $ery transient status ) a person could own a share of stock today and be an 3owner4 and sell his stock the next day5 While shareholders cannot, therefore, pro$ide super$ision of management, it is e*ually ob$ious that there must be some super$ision if the corporate firm is to maintain its $alue. "he solution en$isaged in &' corporate law is the body known as the 6oard of /irectors. In the next section, we will learn more about the 6oard of /irectors and other details of how a corporation is structured today in the &nited 'tates. The "oar# of Dire$tor "he 6oard of /irectors is a body that is elected by shareholders and has a fiduciary responsibility to them. .ffecti$ely, the 6oard of /irectors functions in place of the shareholders+ it establishes the maor obecti$es and policies of the corporation, and appoints and e$aluates its officers. It is supposed to meet periodically to ensure that the corporation is being run in accordance with the obecti$es as laid down by the 6oard. (owe$er, the actual management of the corporation is undertaken by the chief executi$e and by the other officers, appointed by the 6oard, as well as the managers appointed in turn by the chief executi$e. In addition, once a year, there is an Annual 7eneral 8eeting of the shareholders, where all shareholders are entitled to attend and ask pertinent *uestions of the firms managers. While this takes care of the interests of the shareholders, at least in a formal sense, what about the other stakeholders in the firm1 What about the employees of the firm1 What about the bondholders1 We will also see that the establishment of the 6oard of /irectors and the Annual 7eneral 8eeting dont necessarily resol$e the issues that we raised earlier regarding the interests of the firms shareholders. (owe$er, before going on, we introduce the notion of an agent, and the concept of 3agency problems.4 Agen$% &ro'lem We are all familiar with real estate agents and insurance agents. A real estate agent represents a buyer or a seller of real estate, such as a house. 9or example, a person who desires to buy a house may not want to do all the legwork necessary to locate houses that he might be interested in+ so he hires an agent to do the work for him. 'uch an agent sits down with the intending buyer, tries to find out what sort of a house he wants and then goes out and tries to locate it. In general, an agent is an indi$idual who acts on behalf of another indi$idual, called a principal. In any such situation, the problem arises as to how the principal can get the agent to act in a manner that is consistent with his interests+ this is called the agency problem. "here are many agency situations in a corporate setting+ let us look at some of them. "o begin with, the /irectors are agents of the firms shareholders. 'imilarly, the firms managers are agents of the 6oard of /irectors. It is customary, howe$er, to describe the managers are agents of the firms shareholders, which they are, ultimately. It is easy to reali%e the importance of finding good solutions to these agency problems. 9or example, if safeguards are not in place, the firms managers will slack off. "hey will be more concerned with maximi%ing their own well#being and will use the firms resources sub# optimally. "he shareholders, in turn, will not be willing to pay a high price for the firms shares and neither will they be able to sell the shares at a high price. "he lower efficiency of the managers will furthermore result in a lower le$el of compensation for managers. Conse*uently, both shareholders and managers will be worse off. "he difference between the $alue that could be extracted from the firms resources and the lower $alue that is, in fact, extracted is what we term agency costs. Clearly, it is in e$erybodys interests to minimi%e agency costs. 'o what are some of the methods by which managerial agency costs are sought to be controlled1 !olution to the Managerial Agen$% &ro'lem An ob$ious solution to the agency problem is to make the agent more like the principal. In this case, that means that we make the agent :the manager or the director; a shareholder :principal;. In fact, most corporate managers are also shareholders. (owe$er, this does not necessarily sol$e the problem completely ) the manager will often ha$e the temptation to spend excessi$ely on items that gi$e him some pri$ate benefit. 9or example, a manager might buy a corporate et for his tra$el on behalf of the company. While it is true that the et tra$el is being undertaken on behalf of the shareholders, the increased shareholder $alue may be much lower than the cost of the et. While the manager only gets a portion of the increased corporate profits :in proportion to his share ownership;, he gets the full benefit of the comfort of the et tra$el. In order to address such issues, managers are also re*uired to hold stock options. 'tock options gi$e the holder the right to buy shares of stock within a certain time period at a certain pre# specified price called the exercise price. 'ince the 3purchase4 price ) the exercise price ) is fixed, the manager has an incenti$e to take actions that maximi%e the market price of the stock. If the exercise price of the options is chosen properly, the percentage increase in the $alue of the call option can be greater than the percentage increase in the $alue of the underlying stock.. 9or example, 6ruce 6arclay, the chairman of the 6oard of /irectors of 'ur8odics, Inc., a firm traded on the !A'/A0, owned 1,<1=,>>> shares or ?.1@A of the outstanding shares on /ecember B, @>>C. 'imilarly, as of Duly <>, @>>E, the C., of ,racle Corporation, Fawrence .llison, held 1,@C?,ECB,CG> shares, representing about @EA of shares outstanding. In addition, the total $alue of the stock options owned by 8r. .llison as of 8ay <1, @>>C was about half a billion dollars5 In addition to compensation strategies, there are $arious other ways in which conflicts of interest are sought to be eliminated. 9or example, the '.C, in !o$ember @>><, appro$ed proposals by the !-'. and the !A'/A0 that corporate 6oards ha$e a maority of independent directors, who ha$e no material relationship with the company. 9urthermore, companies listed on the !-'. must ha$e audit, corporate go$ernance and compensation committees composed entirely of independent directors. 9inally, outside auditors are supposed to examine the firms accounting statements on a regular basis. 9or firms that issue securities to the public, these accounting statements must be pro$ided to the public. !hort$oming to "oar# Overight In spite of all these precautions, there are many cases where managers ha$e not acted in consonance with shareholder interests. .$en though the firms directors might be independent, ne$ertheless they do not usually ha$e enough of an incenti$e to acti$ely monitor the acti$ities of the firms managers. 9urthermore, there is an information asymmetry between the firms managers and its directors ) the managers are much more closely in touch with the day#to#day affairs of the company, while the directors ha$e to reconstruct from much less information where the actions of the managers were appropriate. In @>>1, after long being lauded as an inno$ati$e and effecti$e company, the C., of .nron Corporation resigned, the C9, was fired and the company filed for bankruptcy. In an attempt to keep the share price high, corporate insiders conspired to tamper with the firms accounting. Harious high#risk and *uestionable techni*ues were used to make it look like the company was profitable and cashflow was steady, e$en though many of the companys in$estments were languishing. According to a study of the .nron episode, published in @>>C by 8eredith /ownes and 7ail Iuss, 1 .nron management withheld key information from the board and the public, a handful of big banks helped the company structure a $ariety of *uestionable transactions and its auditor, Arthur Andersen ga$e .nron its auditing seal#of#appro$al. .$en though board members were paid handsomely for their ser$ices, they failed to respond to a $ariety of warning signs. 9urthermore, many board members did not act ethically. "hey had $arious conflicts of interest that led them to close their eyes to irregularities at .nron. 9or example, in 1BBE, .nron paid Walker2Jotter Associates, a consulting firm, whose chairman was Charts Walker, an .nron director, fees amounting to K<B,?C>. As /ownes and Iuss conclude, 3as a result of .nronLs accounting irregularities, employees ha$e lost their obs, retirees ha$e lost their sa$ings, and executi$es are facing ail time for criminal acti$ity.4 1 8eredith /ownes and 7ail ' Iuss. (Antecedents and conse*uences of failed go$ernanceM the .nron example,4 Corporate 7o$ernance. 6radfordM @>>C.Hol.C, no. C, pp. GE#BG.
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