Monday, August 17, 2009

The Conquest for Immortality and Never Ending Profits: Some Insights on The Management of Corporations

Have you ever wished for immortality? Do you want to live forever and ever, having the luxury of doing whatever you want without any time constraint? I do, but I guess that the chance for achieving such immortality is too slim to be even considered by any rational being. However, other than any mythological creatures out there, there is an entity in this world that might actually have the capacity to achieve immortality. By this, I refer to corporations.

What Are Limited Liability Companies?
While the definition of corporations might slightly differ between various legal jurisdictions, it has several basic characteristics, i.e.:
  • corporations are legal entities established under the prevailing laws which have jurisdiction over such corporations (the domicile where such corporations were firstly originated);
  • corporations are able to maintain their own assets and liabilities, and to conduct various transactions with other parties;
  • corporations are "owned" by the shareholders, i.e. those who have contributed certain amount of capitals to the corporations and received shares from the corporations as evidence of their contribution and representing their ownership within such corporations;
  • there is a limitation of liabilities for the shareholders of corporations (mainly up to the respective shareholder's capital contribution in the corporation);
  • there is a separation of management within a corporation, i.e. the shareholders do not have direct management control of the corporation, instead it is conducted by a separate professional board of management (directors and commissioners); and
  • most corporations, if not all, are established for the purpose of getting profits, enabling them to maintain their existence for a very, very long time.
The legal concept of corporations is unique, because it is considered as a somewhat "living entity" having certain rights and obligations, while in reality it is a business organization made from joint stocks owned by certain party(s). But, only because of such characteristics that corporations are able to have an immortal life and becoming an integral part of the capitalist system.

When Was The First Limited Liability Company Established?
According to Gower's Principles of Modern Company Law, the early concept of corporations can be found in the 15th century, notably on the limitation of liabilities of the owner of such corporations. The oldest known corporation is no other than VOC (Verenigde Oost-Indische Compagnie), the "evil" company that made a reign of terror in Indonesia, and which is also the first company to conduct public offering in this world. Since the establishment of VOC in 1606, the history of corporation has lasted for more than 400 years, and that is quite a long time indeed.

Why People Made Limited Liability Companies?
The logic is quite simple, corporations allow people to have the protection of limited liabilities in doing their business, they can be established for an indefinite period, and their existence does not depend on the existence of their owners. This means that it would be easier for the owners to calculate their risk of liabilities (due to the limited liabilities) and the business activities may continue even after all of the original founders have crossed to the other side, i.e. died.

Prior to the existence of corporations, each man is liable up to all of his assets in doing business activities with other parties. Thus, if something goes wrong, he will be responsible with his entire assets, and he faces the risk of losing everything. In addition, since most of the businesses are being privately conducted by individuals in the form of self-company or partnership, the death of the particular individuals will cause the self-company or partnership ceases to exist. The introduction of corporations solves the above problems, and whoever firstly made this concept must be a genius.

The Role of Law on the Establishment of Limited Liability Companies
Of course, people can't simply establish an corporations and declare that they have limited liabilities to their counterparts solely by themselves, people need some legal support to do that. Without any legal basis, you can't expect people to believe that an abstract entity such as corporations exists. In order to achieve that purpose, we will need the government to step in.

Again, this is another genius concept. By having a state law acknowledging corporations as legal entities and stipulating rules on corporations characteristics, establishment procedures, and its rights and obligations, the existence of corporations has been secured by the law, and no one can argue more on that. With the help of law, corporations are no longer abstract beings. They exist in the vicinity and they can act and enter into various transactions as if they are living persons.

Unfortunately, the concept of corporations is not without any flaws. As we shall see further below, 400 years of existence has brought many issues that might not be considered yet when the corporation is firstly established.

The Chase for Profits and The Impact of Immortality
From the very beginning, a corporation was created to be a profit oriented business entity, and the management of a corporation has an obligation to ensure that such purpose can be satisfied most of the time, if not all the time. Under Indonesian laws, the management of a corporation must act to the best interest of the corporation, which can be interpreted to also include the obligation of the management to ensure that the corporation can obtain sufficient income and profits for maintaining its going concern status, i.e. the ability of the corporation to continue functioning as a business entity for certain period without any threat of stopping or being liquidated.

So, the obligation of the management of a corporation to pursue profits is not a trick made by some evil businessmen, rather it is an obligation stipulated by the law itself. This brings us to an important issue. You see, by having the ability to live an eternal life, there is no limit for corporations in obtaining profits. And since it can't aged, the shareholders would expect the corporation to survive in any kind of condition for as long as it can be. To give incentives to the management, huge salaries and bonuses were given for those who were succeed to make the corporation profitable enough for the shareholders and for those who were failed, losing their position might be the smallest consequence. With this kind of approach, it is no wonder that in some cases, the lust for profit can evolve to a dangerous lust for everything as greed controls the management of such corporation, and when that happens, all would be fair and square enough as long as their lust can be satisfied. VOC would be a pretty example, among with various famous crumbled corporations like Enron and WorldCom.

Can we blame them for that? Not entirely, because whether you like it or not, it is their legal obligation to secure those profits, even if they need to trick everybody. In addition, as I've mentioned above, they were paid by a huge salary and bonus to ensure that the corporation is always profitable for the shareholders. So, do we have some clear incentives for the management to do otherwise? My guess is not, since while some penal sanctions and fines might be a threat to the management, as long as their compensation is highly enough to cover the risks of being sanctioned due to their actions, there would always be a incentive for them to take such risk. As mentioned by Gary Becker, an American Nobel Laureate, crime only happen because it "does pay." See his paper here for more information.

Proposed Policies
Then, what should we do? What kind of policy that should be implemented to solve this problem? First of all, any kind of solution that restricts the corporations ability to obtain profit would be horrendous and will not be accepted. Or can we try the policy used by the US Government with respect to companies that receive US Government's aid, i.e. giving some limitation to the amount of the salaries and bonuses that can be obtained by the management?

My reply is no. The Government shouldn't regulate on the maximum amount that can be obtained by the management. How can they know how to calculate the performance of each member of the management? How can they know that the payment of such huge salaries and bonuses are exceeding the fair limit? A policy like that might give a negative incentive to the management for not doing their best simply because they see that their good results will not be as rewarding as it might be if such regulation does not exist.

Having said the above, my proposed policy would be as follows:

  1. Determination of the form and amount of salaries and bonuses of the management should be conducted by an independent committee within the corporations. This has been done in several Indonesian publicly listed companies, but have not been yet stipulated in a clear regulation. There is of course some additional costs for having this committee but there is also a good ratio for having this committee, i.e.: (i) ensuring that the management can receive a fair reward for their performances based on the calculation of those who are being involved with the corporation, (ii) preventing the management from creating salary and bonus policy that contravenes with the corporation and/or shareholders interests, such as giving excessive shares options with low price to themselves as their bonuses, and (iii) helping the shareholders who are not involved in day to day business activities of the corporation in understanding the performance of the management and how they should be rewarded.
  2. The sanction for the management who breach the laws for the sake of getting profits should be higher than or at least equal with their overall compensation (this include their salaries, bonuses and any type of incomes that they receive due to their illegal acts). This proposed policy is made based on the following assumptions: (i) if their compensation is low, there would be less incentives for them to breach the law; and (ii) if the compensation is high, they will face the risk of losing such compensation or even a bigger amount if they're breaching the law for getting good performances or else for benefiting themselves. As an example: "if the management is deemed guilty for conducting certain amount of crimes, they would need to pay an amount equal to triple times of their total annual salaries and bonuses that they received for the preceding years." Of course, this policy would be only effective if there is a high rate of legal enforcement, something that might not be achieved efficiently as of today.
While some elaborations and implementing provisions are definitely needed for the above policies, I do hope that the ideas presented here can contribute to the development of better policies in managing the balance between lust for profit and the business sustainability of corporations.

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