Abstract
Contemporary academic and policy discussions of corporate governance tend to accord primacy to the interests of shareholders. While the primacy (descriptive or prescriptive) of shareholders is argued for in various ways, others seek to promote a wider stakeholder model of the firm and its governance. In both cases, the interests of creditors tend to be neglected. In this paper, the fundamental position of creditors in a system of corporate law that offers limited liability is reasserted and explained, and the implications explored. It is demonstrated that there are, in effect, two modes of governance possible for a limited liability corporation: the “normal” mode, when shareholders’ interests are primary, and the “distressed” mode, when creditors’ interests are paramount. As a result of this analysis, writers on corporate governance who are influenced by certain managerial myths or economic theories of the firm are encouraged to view the position of shareholders in a more informed light. Writers on business ethics, who often find themselves contending, perhaps implicitly, with inappropriate understandings of the nature of business corporations and their governance, are similarly alerted to the weakness of certain positions perceived as antithetical to their agenda. Finally, business ethicists who advocate a stakeholder perspective are encouraged to recognize the position of creditors and to pay more attention to them as a stakeholder group.
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Notes
In doing this, they are focusing on the divorce of ownership and control famously identified by Berle and Means (1932).
At a basic level, creditors can be divided into trade creditors and finance creditors. Trade credit constitutes the single largest source of short-term funds for many companies (Rigby 2002, p. 75). Finance credit is, broadly speaking, the provision of funds in the form of loans, etc., on which the borrower pays a rate of interest. Unlike trade creditors, “even if lending money is not the principal business of a finance creditor, it is the principal purpose of the financial creditor’s transaction with the company” (McLaughlin 2009, p. 167). What they have in common is that they have a fixed claim to the payment of the principal amount plus any associated interest. Unlike equity shareholders, whose rewards as residual claimants are variable with no entitlement to a return (Maitland 2001), they do not receive extra rewards if the company does well, nor do they lose their right to payment if the company does badly. Furthermore, both are voluntary or “consensual” (Keay 2007) creditors. Generally speaking, the points I shall make apply to involuntary creditors too, such as many victims of torts committed by companies (Davies 2010) or employees paid in arrears. However, some of the points, particularly where I discuss how creditors might protect themselves, apply only to voluntary creditors.
A rare exception is Sorell and Hendry (1994), which has a discussion of responsibilities of, and towards, creditors.
Cf. writing on the so-called business case for ethics, where congruence with the financial interests of shareholders is the focus of attention. (For a review of the empirical evidence, see, for example, Orlitsky et al. 2003.)
Sternberg, for example, writes that it refers exclusively to “ways of ensuring that corporate actions, assets and agents are directed at achieving the corporate objectives established by the corporation’s shareholders” (Sternberg 1998, p. 20, emphasis added).
E.g. normative stakeholder theory.
Where legal matters are referred to in this paper, they will tend to refer to British or US law. Although US law depends, to some extent, on which state is being considered, company law developments in the United States followed the British path more closely than did countries in mainland Europe (Tricker 1984), and the parallels in the economic and legal systems of the UK and United States mean that there are still significant resonances. These parallels or resonances are sufficient for the level of argument of this paper which is not, in any detailed sense, a legal analysis.
Equating wealth maximization with shareholder wealth maximization clearly involves subsidiary arguments, for example, in relation to the issues such as the efficiency of markets (and hence welfare significance of prices), externalities, and whether shareholders are really the only residual claimants (cf. employees who make firm-specific investments, for example—see Blair 1998).
The Companies Act 2006 has, in a section discussed below, introduced the notion of shareholder primacy, albeit in the form of enlightened shareholder value.
This notion of shareholders as members is perhaps a somewhat neglected one that would reward, in the context of business ethics, some further consideration. However, that is beyond the scope of the current paper.
In which case creditors would be part of the corporate governance agenda.
He is referring to the UK but, by extension, it applies to similar regimes.
This ‘trinity’ can be contrasted with Monk and Minow’s (2001) ‘tripod’ of shareholders, management/CEO and board of directors, mentioned earlier.
Winding up of companies is often called liquidation.
After 1862 such provisions were incorporated in company legislation (Keay and Walton 2003).
Nineteenth century judges viewed companies as special cases of partnerships and derived law accordingly.
If protection proves insufficient and creditors find themselves in trouble with an insolvent company, bankruptcy/insolvency law is available—see below. Note, though, that for the argument of this paper, it is not the details of the protections that matters, but the fact that they are included in company law.
Dividends can act as informational signals, as highlighted by modern finance theory.
Greater protection, whatever form it might take, is likely to cost something in some way.
Even if such guarantees effectively removed the benefits of incorporation with limited liability, there might still remain tax advantages from using that form (Klein and Coffee 1988).
Klein and Coffee (1988, p. 219), for example, refer to US federal bankruptcy law as “exceedingly complex”. In the UK, the law relating to the insolvency of companies used to be part of the companies legislation but is now to be found mainly, though not entirely, in the Insolvency Act 1986. This brings it together with personal bankruptcy (Davies 2010). However, notwithstanding the complexity, it is the intentions and general principles that matter for the argument of this paper.
This is broadly in accordance with creditors’ bargain theory, which argues that the goal is to maximize the amount that creditors receive (Keay and Walton 2003).
There are differing requirements internationally (see Parkinson 1993), and there have been over time, regarding when directors should give primary consideration to creditors’ interests; creditors’ interests may be primary not only when the company is insolvent but also when insolvency might reasonably be foreseen. However, this is a technical legal issue and not relevant to the argument of this paper, where it is sufficient to establish that creditors’ interests may become primary at some stage.
See the earlier comments on shareholders as ‘owners’.
Notwithstanding the UK Insolvency Act 1986, I am continuing to bracket corporate insolvency law with company law, which is where its origins lie.
Coffee (2006) argues that the corporate governance debate has also ignored the professional agents of the board and the shareholders, who inform and advise them. However, his interest is in the responsibilities of these parties in relation to the bilateral relationship that dominates the current governance literature, rather than in the legitimate interests of a third principal party, the creditors.
I note that there are legal cases in the UK and the United States which some commentators argue mean that companies do not have to maximize profits (it is certainly the case that they do not have to maximize short-term accounting profits). I also note that, in a closely held corporation, where there is no divorce of ‘ownership’ by shareholders and ‘control’ by executive management (Berle and Means 1932), non-financial goals may have an important part to play, as Friedman (1970) acknowledges.
This paper leaves that an open question.
A ‘degenerate’ one, according to Tocher’s (1970) analysis.
Some US states have passed ‘stakeholder laws’ that permit (or even require) directors to consider the impact of their actions on constituencies other than shareholder, including employees, customers and suppliers (Monks and Minow 2008, p. 48). The UK Companies Act 2006 also appears, prima facie, to be a piece of pro-stakeholder legislation, since Section 172(1) states that directors must have regard to the interests of stakeholders. However, this regard is to be paid while the directors are giving paramount consideration to the interests of shareholders. It is thus an example of ‘enlightened shareholder value’ (McLaughlin 2009), consistent (at most) with instrumental stakeholder theory rather than the normative stakeholder theory propounded by many business ethicists (Donaldson and Preston 1995). ‘Enlightened’ shareholder value is, analytically, no different from shareholder value. Indeed, a member of the steering group whose report led to the passage of the Companies Act 2006 comments that they thought there was a strong case for making explicit the law’s true character, having come to the opinion that it was widely misunderstood in too narrow and short-term a way (Mayo 2008). Moreover, far from being a piece of pro-stakeholder legislation, the 2006 Act actually introduced explicit shareholder primacy in statute law for the first time. Moreover, as a reinforcement of the argument of this paper regarding the place of creditors in corporate governance, it is noteworthy that creditors are not listed alongside other stakeholders in Section 172(1). Instead, Section 172(3) makes the duty to promote the success of the company “for the benefit of its members as a whole” subject to “any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company” (McLaughlin 2009, p. 326).
As Norman (2010, p. 155) comments, “the ‘folk theory of the firm,’ whereby shareholders are special because they own the firm as a piece of private property, is dead”.
A case of functional convergence, even if there is not convergence of form (see Gilson 2004).
Hence, this paper does not make a legal contribution.
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Acknowledgments
The comments of John Boatright, Norman Bowie, Nien-hê Hsieh, Wayne Norman and three anonymous referees on earlier drafts of this paper are gratefully acknowledged.
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Cowton, C.J. Putting Creditors in Their Rightful Place: Corporate Governance and Business Ethics in the Light of Limited Liability. J Bus Ethics 102 (Suppl 1), 21–32 (2011). https://doi.org/10.1007/s10551-011-1190-5
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DOI: https://doi.org/10.1007/s10551-011-1190-5