12th Annual Meeting on Socio-Economics

SSRN Listing

Society for the Advancement of Socio-Economics

London School of Economics

Network H, Markets and Institutions

Sunday, 5 pm, July 9^th, Session 2408

The competitive advantages of stakeholder mutuals

(Last revised September 20th, 2000)

Shann Turnbull

sturnbull@mba1963.hbs.edu

Macquarie University, Graduate School of Management, Sydney

ABSTRACT

This paper compares the competitive advantages of stakeholder mutual firms with firms that are publicly traded, family or government owned. A stakeholder mutual is owned and by its employees, customers and suppliers. These strategic stakeholders can have greater knowledge and commitment to the business than investors. The efficiency and effectiveness of competition for control between stakeholders is compared with competition for control through the stock market in making a firm a competitive. The empowerment of stakeholder constituencies to directly participate in corporate governance is identified as a means for reducing the need for detailed prescriptive government regulation to protect stakeholders. The operating advantages, the flexibility and the competitiveness of a stakeholder mutual is compared with government or private ownership. Examples are used to support the analysis that stakeholder governance can provide a superior approach for increasing efficiency and equity while creating a building block to develop a participatory stakeholder democracy.

JEL Classifications: D890, G380, H190, K290, L200

Key words: Governance, stakeholders, competitiveness, self-regulation, privatisation, ownership transfer, mutualisation, theory of the firm.

PO Box 266,Woollahra, Sydney, NSW, 1350

Ph: +612 9328 7466, Fax: +612 9327 1497, Mobile +0418 222 378

http://members.optusnet.com.au/~sturnbull/index.html

1.0 Introduction

This paper compares the competitive advantages of a stakeholder mutual firm with those publicly traded, family, or government owned in Anglo countries. A stakeholder mutual is owned and controlled by its employees, customers and suppliers. This creates distributed ownership among diversified stakeholders. Each stakeholder constituency elects its own board. These boards represent components of a “compound board”. A compound board introduces distributed control but this does require a stakeholder mutual to have diversified accountability.

In Anglo countries publicly traded, family and government firms typically have a unitary board with homogeneous ownership by investors. This form of governance is compared with distributed control provided by a compound board of a stakeholder mutual with diversified ownership.

Conventional mutuals also have homogenous ownership but it is with a single class of stakeholder. In Anglo cultures a conventional mutual is typically centrally controlled through a unitary board in a similar manner to investor firms. The differences in ownership and control between conventional mutuals, investor firms and stakeholder mutuals are shown below in Table 1, ‘Typology of firms discussed’.

Table 1, Typology of firms discussed

(Heavy arrows indicate the two steps used in the analysis and for forming a stakeholder mutual)

Table 1 also compares the forms of governance used by each type of firm. Hollingsworth & Lindberg (1985: 221–2) state that there are "four distinctive forms of governance ... market, hierarchies, the clan or community and associations"[1]. One type of associative governance is what Pound (1992: 83) describes as the “political model”. Pound states that, "this new form of governance based on politics rather than finance will provide a means of oversight that is both far more effective and far less expensive than the takeovers of the 1980s". Aoki (1998: 32) concluded “that the markets for corporate control cannot provide the best governance mechanism for every class of organizational coordination"”

No firm can exist without employees, customers and suppliers, including those providing infrastructure services in the host community. For this reason these parties are referred to as “strategic stakeholders”.

The distinguishing characteristics of a stakeholder mutual are:

1. Ownership is only with those people on whom the firm depends for its existence,

2. Control is decentralised but not diversified through a compound board.

Shareholders do not meet the test of being strategic stakeholders as they are not required when a firm becomes viable. Viable firms are self-financing and do not need to raise funds from shareholders, as is the case for most publicly traded firms. In some years, more money is distributed to shareholders in the USA from all listed companies through dividends, share buy-backs and management buy-outs than is raised by firms from shareholders.

Jensen (2000), Sternberg (1997) and Pejovich (1990) have noted the problem of firms being accountable to diversified stakeholders. However, their concern does not apply to a stakeholder mutual as it introduces distributed control without diversified control or accountability. Distributed control through a compound board is mandated in a number of continental European countries.

Compound boards are found in all countries, as one company controlling another with outside shareholders creates constitutionally different components of a compound board. This is the predominant control architecture found throughout the world as reported by La Porta, Lopez-de-Silanes, & Schleifer (1999). Compound boards within a firm is a feature of non-trivial employee owned industrial firms throughout the world, even in Anglo cultures where unitary boards are the dominate form (Bernstein 1980). Venture capitalists and leverage buy-out associations who establish over-riding powers for a unitary board through a shareholders agreement also create a compound board.

Ownership by diverse strategic stakeholders is not commonly found except in Japanese keiretsu. Conventional mutual firms, worker cooperatives and professional partnerships have distributed ownership but it is homogeneous within a single class of stakeholder as shown in Table 2, ‘Examples of the different types of firms discussed’.

Table 2, Examples of the different types of firms discussed

Nature of ownership	Examples	Control architecture
Private/solitary	Family firm Government firm	Unitary in Anglo countries, compound boards (CB) elsewhere
Distributed & homogeneous	Publicly traded firm Conventional mutual Professional partnership Worker cooperative	Unitary and/or CB Unitary board Collective Distributed through a CB
Distributed & diverse	Firm in a Japanese keiretsu^a Stakeholder mutual^b	Distributed through a CB but not diverse
Redeemable equity	Mondragón primary coop	Distributed but not diverse (CB)
Limited redeemable	Mondragón secondary Coop	Distributed and diverse (CB)

^aPublicly traded ^bPublicly traded and/or redeemable

The analysis of a stakeholder mutual firm with distributed control and diversified ownership is undertaken in this paper in two steps as indicated by the two black arrows in Table 1. The first step is to compare centralised control with distributed control. The second step is to compare homogeneous investor ownership with diverse stakeholder ownership.

The second section of this paper considers the ‘inherent problems from unitary control’ in publicly traded, family and government owned firms. Unitary control introduces the corrupting influences of centralised power, the problems of information overload and degraded information and control. This section identifies the need to recognise the limited ability of individuals to transact information, measured in bytes, on a reliable and consistent basis.

In the third section, examples of distributed control are considered with a division of power, decomposition in decision making labour, distributed information feedback, and elements of self-regulation. The examples include employee owned firms, the stakeholder-controlled firms found in Japanese Keiretsu and the stakeholder cooperatives located around the Basque town of Mondragón in Spain. The examples provide a basis to compare the competitive advantages of distributed control with centralised control to undertake the first step of the analysis.

The fourth section describes how a stakeholder mutual can be formed through privatisation or by the introduction of tax incentives for shareholders to convert their firms. The resulting information and control architecture of a stakeholder mutual is presented. This provides the basis for undertaking the second step of the analysis in comparing homogenous and diverse ownership.

The fifth section introduces cybernetic principles to provide supporting evidence for the competitive advantages of stakeholder mutuals. First, cybernetic principles identify how distributed control can be used to minimise the need for individuals to transact bytes/data/information/knowledge/wisdom, so as to reduce information overload and “bounded rationality” (Simon 1961: xxiv). Second, they show how to introduce elements of self-regulation to reduce the need for government oversight. The concept of “social tensegrity” is introduced as a method for efficiently managing the problems created by the limited, inconsistent and contrary operating characteristics of people.

The concluding sixth section reviews the competitive advantages of stakeholder mutuals and the introduction of cybernetic principles to the theory of the firm. It recommends the introduction of distributed stakeholder governance before any government enterprise is privatised. It also argues that unitary boards do not represent a competitive basis for the convergence of corporate governance regimes found in various countries.

If governments wish to raise funds by selling their enterprises then the paper argues that this be done on condition that diversified stakeholder ownership is introduced after the investor’s time horizon to introduce the foundations for “building a stakeholder democracy” (Turnbull 1994a,b).

2.0 Inherent problems from unitary control

This section considers the inherent problems of unitary control. Firstly there is the ability of centralised power to corrupt directors and firm performance due to their manifold conflicts of interest. Secondly, centralised control denies the ability of directors to obtain qualitative information about the business strengths, weaknesses, opportunities and threats (SWOT), independently of management who need to be a crucial element of any evaluation. Thirdly, there is lack of information, independent of management, to monitor, control, direct, remunerate, and retire management. Fourthly, unitary control introduces information overload on decision-makers and other shortcomings identified by the cybernetic analysis presented in section five.

Unitary control occurs when a single board or control centre governs a firm. Many unitary board firms overcome some of the problems of centralised control by having a supervisory board such as is found in keiretsu, continental Europe and/or through an influential shareholder who carries out the role of a “watchdog” or supervisory board.

2.1 Corruption of power

A unitary board has absolute power to manage its own conflicts of interest. Table 3, ‘Corrupting powers of a unitary board’, explicates how unitary boards can lead to the corruption of both its members and the performance of the business by appropriating shareholder value. Section A of the Table lists the powers of directors to further their own interests or those of their nominees. Section

Table 3, Corrupting powers of a unitary board

Directors have power to:

A. Obtain private benefits for themselves (and/or control groups who appoint them) by:

(a) Determining their own remuneration and payments to associates

(b) Directing business to interests associated with themselves

(d) Selling assets of the firm to one or more directors or their associates at a discount

(e) Acquiring assets from one or more directors or their associates at inflated values

(f) Trading on favoured terms with parties who provide directors with private benefits

(g) Using firm resources and/or their status in other ways.

B. Maintain their board positions and private benefits by:

(a) Reporting on their own performance and influencing “independent” advisers by:

(i) Selecting auditors and other “independent” advisers

(ii) Determining their fees

(iii) Controlling the process by which auditors are appointed by shareholders

(iv) Terminating the appointment of auditors and other “independent” advisers

(v) Paying additional fees for work which is not required to be “independent”

(vi) Determining the terms of reference on which “independent” advice is provided

(b) Determining the level of profit reported to shareholders by:

(i) Selecting the basis for valuing or writing off trading and fixed assets

(ii) Determining the life of assets and so the cost of depreciation

(iii) Selecting the basis for recognising revenues and costs in long term contracts

(iv) Selecting accounting policies within accepted accounting standards

(v) Selecting, controlling and paying “independent” valuers and determining the basis on which valuations are to be carried out

(d) Determining how any conflicts of interest are managed

(e) Filling casual board vacancies with people who support their own positions

(f) Nominating new directors who support them at shareholder meetings

(g) Controlling the nomination and election procedures and processes

(h) Controlling the conduct of shareholder meetings

(i) Appointing pension fund managers for the firm who also provide them proxies

(j) Voting uncommitted proxies to support their own election

(k) Not allowing the firm to compete with related parties who can vote for them.

B lists the powers of directors to maintain their board position and benefits for themselves and/or their nominees. The natures of the eight conflicts of interest listed in section A can and have been used to destroy the viability of many publicly traded companies. This should not be unexpected as it is widely accepted that power corrupts and absolute power can corrupt absolutely.

The inherent conflicts of interest in unitary boards are gradually being recognised by the growing practice of establishing sub-committees to consider the more contentious conflicts. However, while such sub-committees acknowledge the problem they are not a solution, as boards cannot contract out of their intrinsic conflicts of interest. The most common and contentious conflicts arise from directors determining (i) the accounting policies that determine the how their performance will be assessed by investors; (ii) the remuneration paid to themselves; and (iii) their self-nomination for re-election. For these conflicts to be properly managed, a company requires a watchdog board or an active influential shareholder to carry out this role.

The appointment of a majority of non-executive directors (NEDs) to contentious board sub-committees does not remove the intrinsic board conflicts even if the directors are described as “independent”. The term independent is generally misleading “double-speak”. This is because the information available to NEDs to make decisions is prepared by management and so is not independent of the self-interest of management. The information prepared for NEDs is commonly the principle source of information available to NEDs to direct, monitor, control, remunerate and change management.

It should be considered misleading and deceptive conduct under the law to describe any director on a unitary board as “independent” unless they can meet three conditions. The three conditions are that the director has: (i) information independent of management on which to act; (ii) the will to act; and (iii) the capability to act in the best interest of the company as a whole.

2.1.1 To obtain the information to act, directors not only need management’s side of the story but any opposing views that may be held by employees, customers, suppliers and other stakeholders. A “loyal opposition” and a vigilant “fourth estate” are commonly recognised as conditions precedent for good government. As the ability to sustain any business depends upon its strategic stakeholders, it is simple good common sense for directors to establish processes for obtaining information from such people and to establish their long term commitment, support and cooperation.

2.1.2 To obtain the will to act, directors need to hold their board positions independently of those whose interest they may need to act against to further the interests of the company as a whole. The membership of boards is commonly self-perpetuating. This makes it difficult for any one individual to act against the collective self-interest of the board to maintain their self-serving and self-perpetuating power, status and privileges as listed in Table 3.

The method of electing directors is commonly controlled by the directors or by the chairperson. This makes any individual director vulnerable to retirement if she is not a “good team player”. The will to act independently can be encouraged by directors being elected by preferential voting. This also protects minority interests as it allows them to be represented to protect them from being exploited by any “control group”.

A form of preferential voting, which is mandated in some states in the USA, is described as “cumulative voting” (Bhagat & Brickley 1984, Dallas 1992, Gordon 1993). Under this system, all directors are elected each year with each share obtaining as many votes as there are vacancies on the board. Shareholders can then distribute their votes amongst the directors of their choosing. If there are ten positions to be filled then each share has ten votes and a 10% shareholder can accumulate sufficient votes to ensure that at least one director of their choice is elected. In this way minority interests can obtain some protection from what Hailsham (1978: 125) described as “elected dictatorship”. Cumulative voting avoids boards becoming poorly accountable when they use the various powers listed in section B of Table 3 to make themselves self-perpetuating.

2.1.3 To obtain the capability to act, directors need a process to prevent unethical and/or counter productive practices before they occur. In Anglophile countries directors are faced with the option of resigning and allowing undesirable activities to continue, or ignoring them as a “good team player”. Regulators are of little help to prevent a problem arising. Regulators normally take the position that they will only become involved once it is evident that “the horse has bolted”. To close the stable door before hand, a director needs to obtain either a board majority to support preventive or corrective action or a watchdog board to veto the matter.

Watchdog boards, described as “Cour des Comptes” are mandated in France for government owned firms (Analytica 1992: 104). Financial institutions in France have watchdog boards described as “Censeurs” (Analytica 1992: 107). Similar types of watchdog boards are mandated for cooperatives in Spain as found in the Mondragón Corporacion Cooperativa (MCC) described by Turnbull (1995). The author has introduced watchdog boards to Australia in two start-up enterprises he formed to reduce the cost of raising high-risk funds. They also and protected his reputation as a professional company promoter (Turnbull 1992b, 1993, 2000a).

Watchdog boards have limited roles. Their main role is to avoid the situation of directors setting, marking and reporting on their own exam papers. This can occur because directors establish their own profit objectives and have considerable discretions under accepted accounting standards to determine the reported profit as discussed by Bazerman, Morgan & Loewenstein (1997). Their findings support the view of Tricker (1994: 246) that directors are in the position of “marking their own exam papers”.

The watchdog boards that were established by the author mediated any conflicts of interest, including those commonly managed by the audit, remuneration and nomination committees. In one situation the watchdog board also had the power to stop the author and his co-directors from over-borrowing by having the name of the watchdog board chairman on the title deed of the land owned by the business.

2.2 Lack of independent feedback information on performance

A fundamental flaw in the Anglo system of corporate governance is that directors can be given the “mushroom” treatment by management. That is, they are kept in the dark and given informational manure. There are two reasons for this state of affairs. Firstly, in Anglo countries, institutional investors, who in aggregate may typically hold a majority of the shares in publicly traded companies, do not have any firm specific knowledge or authority to provide meaningful oversight, alternative intelligence or assistance to the directors.

Secondly, the unitary board structure in Anglo countries means that directors become largely captive to the information provided by management. Compare this situation with that of a company in a Japanese keiretsu as illustrated in Figure 1, ‘Anglo unitary control compared with Japanese distributed control’. Figure 1 illustrates Japanese diversified stakeholder ownership, which is created by firms issuing shares to their supplier and customer corporations to consolidate their relationships with them. The chief executive officers (CEOs) of these strategic stakeholder companies meet once a month, or even once a week to discuss operations.

The feedback information that these CEOs obtain from their subordinates provides the other side of the storey of any operational problems in the procurement or marketing of goods and services. The resolution of any problems or shortcomings in the quality or terms of trade can be crucial in obtaining competitive advantages. News of problems may not be reported or be reported slowly, by subordinates, especially when they think management could regard the problems as reflecting on their own performance. It is a case of subordinates fearing that managers may “shoot the messenger”. By providing access to both sides of the story, a keiretsu council is more likely to hear about problems, which might not otherwise be identified. As a keiretsu council meets frequently, problems can be both identified and corrected expeditiously. Formal communication between suppliers and customers also allows both parties to contribute to resolving problems and developing cooperative relationships for increasing efficiencies.

Figure 1, Anglo unitary control compared with Japanese distributed control

(Anglo investor ownership compared with Japanese diversified stakeholder ownership)

Without a self-correcting feedback information from informed and committed diversified stakeholders as illustrated in Figure 1, a firm governed by a unitary board is subjected to jeopardy from a lack of information or self serving biased information on its operational performance. This is a common problem in all public and private sector command and control hierarchies.

Without independent qualitative and quantitative feedback information, directors of a unitary board do not have a creditable basis to direct, monitor, control, remunerate or change management or undertake a SWOT analysis of the business. In such situations there remains little operational reasons for a firm to possess a board. In the larger companies the role of the board becomes one of providing privileges of power, status and influence and maintaining these by distributing such benefits to those who support the self-perpetuation of the practice. However, Bhaghat & Black (1998) provided evidence that the value of external directors was to influence or capture regulators. Also, to allow CEO’s to spread the blame when performance declined.

2.3 Loss of information and bias

Communications passing up and down any organisational hierarchy can suffer quite serious misunderstandings, mistakes and omissions when relayed through just three or four people, even when all individuals possess the very best of intentions. When these people are in a management hierarchy, it is rarely in their self-interest to report to a superior, information that may reflect adversely on their own performance. This provides an incentive for biases, distortions and omissions in communications. The need to interpret information sent down a chain of command and condense information reported back up increases the problems of control and monitoring. These problems are common to hierarchies in both the private and public sectors. They have been analysed by Downs (1967: 116–8) and illustrated along the lines shown below in Table 4 ‘Loss and distortion of information in a hierarchy’.

Table 4, Loss and distortion of information in a hierarchy

HIERARCHY	INFORMATION UPWARDS			EMPLOYEES
(public or private sector)	Volume	Correct	Missing	(span of 5)
Legislature	(50% lost/	(85% of	or wrong	per	accumulated
Minister/shareholder(s)	level)	lower level)	meaning	level	total
Board of directors	3.1%	1.4%	98.6%
Chief Executive Officer	6.3%	3.3%	96.7%	1	1
Senior management	12.5%	7.7%	92.3%	5	6
Middle management	25.0%	18.1%	81.9%	25	31
Team leaders	50.0%	42.5%	57.5%	125	156
Workers	100.0%	100.00%	0.0%	625	781

Downs assumed that the biases of officials resulted in 10% of the true meaning of the information being lost each time it was relayed through each level. He also assumed that 5% of the true meaning is lost from errors in transmission. The loss of meaning and errors reduced the correct information by 15% per level. Correct information would only represent 85% of that which was condensed by 50% at each level. The cumulative compounding result in a hierarchy of five levels each with a five person span of control is shown in the "correct" and "missing" columns of Table 4. The table highlights the possibility that even the chief executive officer (CEO) may not have the information required to regulate the organisation and illustrates the point made by Jensen (1993: 864) that, "Serious information problems limit the effectiveness of board members in the typical large corporation".

2.4 Information overload