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March 28, 2005

Who is the Owner of a Company?
Maximization of Shareholder Value is the Goal

Takaaki WAKASUGI (Professor, Tokyo Keizai University)

In a capitalistic economy, which presupposes private property ownership, a company is a private property with an owner - its shareholders. But as the law grants judicial personality to corporations, and a person cannot be owned in a society where slavery is prohibited, no "owner" of a corporation exists from a legal point of view. Accordingly, when shareholders are referred to as the "owner" of a company, it is not a legal claim but a description from an economic perspective.

The question, then, is whether it is fair in a social context to delegate governance of a corporation solely to shareholders, for the reason that they are the owners of the company. The key to answer this can be found in market principles.

Corporate risk is borne by shareholders

The private property system is one in which all property is recognized as being owned by someone who has the right to control or dispose of that property, but who must also bear the responsibility for any (including adverse) consequences of that control. The owner must bear responsibility for all such eventualities, for better or worse. This is called ownership risk.

In a stock company, shareholders - as a corollary of ownership - exercise governance over the company, which in turn burdens them with corporate risk. Shareholders receive the remnants of sales proceeds after subtracting various costs. This is commonly dubbed "profit," but it is essentially a leftover. Under a capitalistic system where a fair and efficient economy is sought through open markets and free competition, there is inherent risk in carrying out various aspects of business. Accordingly, there could be some risk remaining in the leftover recognized as profits, which shareholders must also shoulder. In addition, employees' basic wages are fixed, terms of conditions with customers and suppliers are predetermined, and contracted interest is to be paid to creditors. This leaves only shareholders who can bear risks. There may be, however, cases in which business performance deteriorates significantly and the company becomes bankrupt, extending the risk burden to its employees and suppliers.

There are many types of stakeholders for a company. Employees seek income to sustain their livelihoods, customers purchase products to support their daily lives, suppliers trade, and creditors set sights on increasing their wealth. In that sense a company is supposed to serve everyone, thus revealing its function as a public organ. Moreover, a company cannot survive if it lacks the support of any of these stakeholders. The capitalistic system assumes that market mechanisms are socially fair, as terms of business are determined by balancing supply and demand in environments where companies and individuals are competing against each other. Even if shareholders' intentions were only to maximize their own profit, when the company deals with its stakeholders the balancing mechanism kicks in. This, in effect, would result in respecting stakeholders' interests. But for such a mechanism to work, competition must be conducted on even ground. Legal frameworks have been developed to guarantee such equal footing, as in Antitrust Law, Labor Standards Law, and Household Goods Labeling Law, among others.

Seeking shareholder value increases GDP

The capital market in the modern world was established to provide large corporations with capital and equity, and large companies issue a large number of shares to collect needed capital. Shares thus issued circulate, and other corporations and individuals purchase and own them at their free will. As shareholders alternate constantly, it is neither efficient nor practical for them to manage a company even though they may have the right of governance of the company. Therefore, the shareholders appoint directors of the company, entrusting the board of directors with the responsibility of managing the company. Shareholders do not operate the company themselves but they exercise their governance through choosing executive directors. This is a reflection of the modern legal system acknowledging the realistic notion that shareholders are the owners of a company in economic terms.

When people earn income through work, many dispose most of it for their livelihood, but some people set aside a portion of their income to save for the future. People purchase shares to increase their savings, by thus becoming an individual shareholder, or deposit it in financial institutions. Financial institutions in turn purchase shares to become institutional investors.

The aim of individual or institutional investors is to increase their assets, so they hope for the value of shares, i.e. stock prices, to rise. Directors and executive managers who are assigned by the shareholders to run the company thus seek to maximize shareholder value.

The task of directors and executive managers is to create value for shareholders while complying with laws and other rules of society, and also respecting and catering to stakeholders. Employees need to be assured of a reasonable income, too. The sum of employees' income, interest income for creditors, and shareholder value comprises the added value of a corporation. GDP is defined as the aggregate of added value of all corporations. Thus GDP can be increased by companies seeking maximum value for shareholders. In other words, it is a responsibility of a company and its managers to seek shareholder value while acting in compliance with set rules. And it is the responsibility of shareholders, by exercising governance, to see that such management style is exercised.

When a company develops a new product and intends to start a new business, it needs to raise capital, which incurs certain costs. When the profit margin of the new business supersedes the cost of capital, the business will produce excess profit. Then the shareholders can claim rights to this profit. When the company's investment is deemed sound and excess profit seems attainable, it invites stock price increases in the market. And when in fact the profit materializes, shareholders can enjoy even higher share prices. This is what is meant by shareholder value creation.

Replacement of majority controlling shareholders could create new values

Suppose a company is engaged in a potentially profitable business but poor management is suppressing its profit, and, accordingly, stock prices. Investors, including individuals and other companies, recognizing this situation could purchase a majority share of that company, and by exercising governance could replace managers or change the ways of running the business. If the company can be transformed to produce profit as expected, their share prices would rise. This is how shareholder value can be created through acquisition.

Similarly, a company sitting idly over large financial assets on their balance sheet could become a target of M&A, because the company may be regarded as badly managed for not utilizing its resources productively. Then there may be cases where two companies with different business objectives could merge and enjoy a synergy effect by creating a new profitable business.

M&A is a means to transfer governance to new shareholders that could provide for an opportunity to transform inefficient companies into productive ones or enable sagging companies to bring forth new profitable business. It contributes to value creation and increases the efficiency of the economy of the state. This is why a stock market where transfer of governance can take place is important. In the U.S., the stock market is sometimes referred to as "the market of company governance."

Japanese companies currently are in the doldrums due to changes in the economic environment such as globalization. M&A can be an effective mechanism to revitalize business activities. But unless the principle of shareholder governance is firmly established, M&A transactions could be manipulated by brokers and agents, leading to unproductive M&As that do not create shareholder value. M&As are becoming active in Japan, but it is necessary for people to realize the importance of shareholder governance, which has been neglected in the past.

(The original Japanese article appeared in the March 22, 2005 issue of Nihon Keizai Shimbun.)

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