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.

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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).

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(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.

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(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

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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.”

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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).

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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. “”

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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.

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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.

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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

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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.

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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).

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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.

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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

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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.

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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

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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).

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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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