3CL, 27 January 2016 Do corporations increase inequality? ewan.mcgaughey@kcl.ac.uk

1. 3CL, 27 January 2016 Do corporations increase inequality? ewan.mcgaughey@kcl.ac.uk

2. Classical economic theory said markets were meant to deliver equality.... A Smith, The Theory of Moral Sentiments (1759) Pt IV, ch 1, ‘The rich... consume little more than the poor, and... though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they... are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided intoequal portionsamong all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society...’

3. But not in a world of corporations (rather than small partnerships of butchers, bakers, brewers) A Smith, The Wealth of Nations (1776) Book V, ch 1, §107, ‘The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.... Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.’

4. Basic problem of rising inequality • Piketty, Stiglitz, Pickett and Wilkinson: inequality is rising; corporate governance is a ‘pre-tax’ cause. But how, exactly? • Majority view is that returns to labour and capital (wages, dividends, interest) do not merely reflect the marginal utility added to production – bargaining power shapes stakeholder income. • Further, inequality is an economic efficiencyproblem (as well as a moral or fairness issue) because unjust enrichment of a few at the expense of the many damages motivation to work. It reduces production, aggregate demand, and concentrates the risk of systemic collapse.

5. ‘Significantly distributive rules’ • Those which allow people to influence the board’s distribution function (paying wages, dividends, making contracts, holding property) the most. • The core example is the right to vote for who is on the board (as opposed to directors’ duties, rights to bring derivative claims, rights to sell shares, etc). • Basic theory:if you get to participate in choosing the people who pay you, they will pay you more. If someone else determines who pays you for your contribution, there is a risk they will unjustly enrich themselves at your expense.

6. Analysis limited to private enterprise • It is doubtful that there is a ‘one-size-fits-all’ theory of enterprises, to include those where general laws of competition and insolvency law are not enough to protect the consumer or public interest (e.g. water, rail, energy, banks).

8. Executive pay • UK: say on pay and back again? • US: almost the same?

9. Standard historical pay rules: UK • UK, Companies Act 1862, Table A, art 64, director remuneration ‘shall be determined by the company in general meeting.’ • N Lindley, The Law of Companies (5th edn 1889) 303, directors had ‘no power to vote themselves fees for salaries for their services beyond what the constitution of the company may provide’. At 337, fn(g) ‘The directors may appoint one of themselves to be a manager at a salary, but the person so appointed ceases by the appointment to be a director’: Eales v Cumberland Black Lead Mine Ltd (1861) 158 ER 198.

12. Standard historical pay rules: US • Compensation was fixed by a corporation’s charter, or changed through the bylaws by a majority of members. • V Morawetz, A Treatise on the Law of Private Corporations (2nd edn Little, Brown and Co 1886) vol I, §508, it ‘would be contrary to established principles to allow the directors or other agents of a corporation to fix their own compensation’.

14. Basic summary • In the UK and US, the general meeting usually had, but then lost, a binding say on pay. • The times when that loss occurred (in default rules of company constitution) do not immediately trigger rising executive pay, but enable directors to take advantage of their conflicted interests. • But why is there a time lag? Also, even if shareholders lose a say on pay, in the UK, and often in the US, shareholders can still dismiss a board if it doesn’t control its pay. Why didn’t that happen more? We need to understand who shareholders are.

17. Asset managers and beneficiaries • Separation of contribution and participation • Mass conflicts of interest

18. Essential points 1. There was an historical shift in the late 20th century from individual to institutional share ownership. Most of this is retirement saving money (in pensions, life insurance, mutuals). 2. Asset manager intermediaries appropriated votes with ‘other people’s money’ - a doubling of the agency problem: another separation of contributors to equity from participation in governance. 3. Asset managers took over most shareholder voting rights as (i) executive pay rose, and (ii) the finance sector was consuming more GDP.

19. Separation of contribution from participation • The typical investment chain: employee/individual → pension fund/life insurance co/mutual fund/corporation → asset manager/bank/broker → custodian/nominee → company director • Generally, shareholders can hold directors to account through the vote, and some employees have votes for the pension fund. • But asset managers are usually the shareholders and are typically unaccountable to the ultimate investor: asset management contracts often contain no voting arrangements.

20. Mass potential conflicts of interest • Basic theory: if an asset manager sells a retirement product, and controls shareholder votes, it will induce corporations to buy its retirement product, eg, pressure for individualised pensions, contract pensions, 401(k)s over collective plans (DC, not DB) • Asset managers will further attempt to sell complex products to make more fees by hedging + churning • Mass conflict of interest, with mass self-dealing, inflates the size of the whole financial sector. • So far as executive pay goes, asset manager who are highly paid will not challenge board pay.

24. Conclusions 1. Asset managers have an incentive to keep board pay up if they are also well paid. Their interests diverge. They can profit from their office rather than by working hard. This is an extension of the managerial agency problem. 2. The financial sector is able to inflate its income through using shareholder voting rights to make corporations by their products. 3. This increases inequality by concentrating income in one sector – finance – at the expense of a productive economy.