The Ethics of the New Finance

James O. Horrigan

ABSTRACT. This paper examines the normative ideas flowing from the contemporary theories that make up the New Finance. These theories include the Irrelevance Theorem, Efficient Market Hypothesis, Capital Asset Pricing Model, Options Pricing Model, and Agency Theory. The behavioral consequences that would ensue if everyone took the normative precepts of the New Finance seriously are subjected to a Kantian analysis to determine their ethical implications. It is concluded that the corporate world in the New Finance is a place where the firm can select any operating and financial strategies that it wishes, and the investors will respond immediately through a combination of homemade portfolio diversification, clever option positions, and carefully constructed agency relationships, all of which results in a pervasive nihilism. Recommendations are offered on how these features of the New Finance might be avoided or moderated.

Introduction
The sweeping development o f financial management Theory over the past twenty-five years is truly one of the more impressive intellectual achievements in the history of business education. Economic equilibrium analysis and positivistic empirical research have transformed a previously descriptive, institutional subject into an elegant, theoretical branch of knowledge. A coherent framework now exists for addressing

Dr. James O. Horrigan is the Forbes Professor of Management at the Whittemore School of Business and Economics of the University of New Hampshire. He has published articles on accounting and finance in the Accounting Review, Journal of Accounting

Research, Journal of Business Finance and Accounting, and Journal of Finance.

questions concerning the allocation of scarce resources through the pricing of risky assets. [29] This framework, which I shall call the "New Finance," touches on virtually all problems requiring financial decisions. The New Finance's conceptual and empirical underpinnings have been subjected to fairly extensive criticism, 1 but its ethical foundations have been generally ignored. 2 This paper is an exploratory, teleological analysis of the ethical implications o f the New F i n a n c e ) The basic maxim of this paper is that ideas have behavioral consequences, especially when they become incorporated into pragmatic subjects. Most of the ideas absorbed into the New Finance come from positive, relatively valuefree subjects, such as financial economics, so it is tempting to dismiss their ethical implications as a non-question. However, positive ideas inevitably become normative ideas when they are promulgated in decision oriented subjects, such as financial management, and they warrant ethical examinations at that point. The exact timing of such a transition is not always obvious, but I do believe that it is reasonable to assume neutral ideas have become ethics laden when they appear in management textbooks. On that basis, the time for an ethical analysis of the New Finance has arrived because it has begun to seep into the leading textbooks of financial management. [6, 26, 30] This analysis shall proceed as follows: First, the major ingredients of the New Finance will be briefly described. Second, the ethical analytical approach to be used in this paper will be introduced. Third, each part of the New Finance will be closely scrutinized to determine the modes of behavior we can expect to emerge as

Journal of Business Ethics 6 (1987) 97-110. © 1987 by D. ReidelPublishing Company.

Fourth. principle oriented mode. an important caveat is in order here: the analysis of the possible consequences will be deliberately critical and will concentrate largely on negative consequences. The backdrop. the general corporate decisions in finance. behavioral implications of the New Finance. profit maximization by corporations could be ethically justified in a teleological mode if it leads to behavior with favorable consequences for society. but they blend together. the Options Pricing Model. The Options Pricing Model postulates that all equities in a firm are simply different combinations of options to buy and sell the firm's assets. linking all of these parts is perfect capital markets driven by a perpetual pursuit of shareholder wealth maximization. as it exists. 6 The basic thesis here is that "undesirable" behavioral consequences consist of any violations of Kant's "categorical imperative. The Irrelevance Theorem States that. a nexus for contracting relationships between stockholders. Undesirable outcomes will be evaluated through the use of a modified Kantian analysis. under the assumption that decision makers will actually try to apply it pragmatically to their problems. the only risk that matters is the volatility of a firm relative to the economy as a whole. Financial decisions spring from inherent conflicts between those groups. 4 Each of these parts are theories in their own right. The Capital Asset Pricing Model argues that risk caused by events unique to a firm is irrelevant because investors can easily eliminate it by portfolio diversification. no attempt will be made to suggest what principles should have been used in developing the New Finance. and Agency Theory. Essentially.) That is. into a grand theory of financial management. Profit maximization could be justified in a deontological mode if it reflects the exercise of basic rights and liberties. managers. As a result. a teleological. and other groups. The New Finance In its present state. such as private property. albeit loosely in some instances. In other words. especially decisions involving capital structure and dividend policy. 5 (For example. a point which I shall leave up to the reader's judgment. Horrigan that part increasingly becomes accepted as utilitarian and pragmatic. which are exacerbated by information asymmetry between the groups. Agency Theory states that a firm is simply a legal fiction which serves as Ethical analytical approach Before going on to an examination of the ethical. consequence oriented mode of analysis will be used. the Capital Asset Pricing Model. or perhaps the deus ex machina.98 James O. such a consumer satisfaction. the New Finance consists of five major parts: the Irrelevance Theorem. The Efficient Market Hypothesis asserts that security prices always fully reflect all publicly available information and any newly released information is absorbed rapidly and unbiasedly into security prices. as opposed to a deontological. do not matter because investors will simply adjust their strategies to offset any disequilibria created by the corporate decisions." In Kant's words: . bondholders. I would like to describe briefly the ethical analytical approach that shall be used. However. more balanced approach which weighs and sums up the "pluses" and "minuses" might lead to somewhat different conclusions. Consequently. An extended. recommendations shall be offered as to how the New Finance should be approached in future developments in the subject of financial management. I am interested only in the possible behavioral consequences of the theory. financial strategies of the various corporate investors will evolve from the apparent volatility of a firm's operating earnings. Therefore. financial analysis will not necessarily yield superior returns to an investor. the Efficient Market Hypothesis. the ethical analysis used here avowedly focuses on undesirable behavioral outcomes of an implementation of the New Finance. Finally. given the firm's investment policy. and finally.

In effect. what would be the moral condition of the financial world?" 8 Thus. behavioral consequences that would ensue if everyone took the normative precepts of the New Finance seriously. In effect... The Irrelevance Theorem Reduced to its simplest terms. Accordingly." but it allows for a broader focus on ethical behavior because it includes all human acts. corporate decisions on such matters as capital structure or dividend policy are instantaneously offset by arbitrage decisions by individual investors. although our ultimate concern is with the morality of the New Finance. "Do unto to others as you would have them do unto to you. but they do not add to that total value. The first idea is a general argument that the total value of a firm is determined only by its "real" activities. However. Kant's imperative is very similar to the Golden Rule. This idea is particularly prominent in regard to capital structure decisions where choices are being made between debt and owners' equity. nonetheless the Kant categorical imperative allows us to frame the question as a practical consideration that concerns the results of an action. Whatever choice the firm makes will be immediately reflected in security market adjustments. A related notion here is that. that preserve the total value of the firm. so corporate managers should concentrate on real decisions involving the production of goods and services. "in order for a corporate decision to be a thing of value. . to put it differently. to put the question slightly differently. flows from two basic ideas. of the various equities' risk and return positions. only one categorical imperative. and possibly improve upon. the Irrelevance Theorem. an undesirable behavioral consequence of the New Finance would be the encouragement of any financial rule of conduct in a specific case that we would not desire to be the behavior followed in all cases. the relevance of corporate financial policies would depend only on certain "imperfections" in the real world. The second idea is an axiom that individual investors can imitate. financial decisions might be quite relevant for individual equities but are irrelevant for the firm as a whole. let us proceed to raise this question for each of the individual parts of the New Finance. p. even if the corporation could somehow increase the total value of the firm through clever financial manipulations. most corporate financial strategies in their own personal finances. 7 Kant's "maxim" is often interpreted to mean the reason for which a person carries out an act. we must consider the ethical. Therefore. Now. the notion that most corporate financial decisions do not matter. It is: Act only according to that maxim by which you can at the same time will that it should become a universal law. The tax benefits associated with the deductibility of interest payments are often cited as an important imperfection that would encourage firms to use large amounts of debt in their financing. but it is used here in its literal sense of a general rule of conduct. the various equityholders would quickly wipe out such increments in value through arbitrage in the capital markets. by the production and sales of goods and services and its investments in assets to carry out those activities. a decision maker operating within a Kantian framework must ask himself or herself: "If everybody did the same thing.. 9 Bankruptcy costs and agency costs.e. Financing decisions allocate the total value. i. 302] puts it. between the various equities in the firm. [19] o f course. the company must be able to do something for stockholders that they cannot do for themselves." If homemade strategies are possible. As Van Home [26. or.The Ethics o f the New Finance 99 There is . capital market imperfections might create the possibility of increasing the value of a firm through financial decisions. Or. the Irrelevance Theorem rests on the existence of perfect capital markets. before making a financial decision. so it is not even clear that corporate managers should concern themselves with achieving optimal financial decisions for their individual equities. however indirectly or directly they may bear on other individuals. a point to which I shall return to below.

it seems plausible that investors would by and large determine the optimal strategies that they should pursue by studying the optimizing behavior of corporations. However. The "semistrong form" tests have determined that security prices also reflect all other publicly available information. but the important point is that the preferences of investors would receive scant consideration in light of the Irrelevance Theorem. and institutional restrictions might be quite dig ferent than those of the corporation. In efficient markets. preferences of investors would receive little attention because it would be presumed that they would pursue homemade strategies. In other words. it is acknowledged that investors may not be able to follow homemade strategies perfectly. "Weak form" tests have established that current prices fully reflect historical price information. the Irrelevance Theorem leaves us with the notion that the relevance of corporate capital structure decisions hinges on the possibility of bankruptcy and the existence of agency costs. managers can be expected to pursue their own self-interests. superior returns cannot be earned by merely looking for patterns in stock prices. Consequently. which is to say that there is no discernible systematic pattern which an individual could use to advantage as an investor. Finally. especially accounting data. or suboptimal dividends. Thus. arbitrage requires that an optimum position exists somewhere. the overarching ethical implication of the Irrelevance Theorem is that the basic obliga- tions of the firm to its investors would receive inadequate attention. The Efficient Market Hypothesis Basically. [10] Extensive empirical tests of the Efficient Market Hypothesis have been conducted. In any case. neither of which have known functional re!ationships . Horrigan which will be discussed below. so capital structure ends up as an indeterminant variable. non-public . the Efficient Market Hypothesis states that security prices always fully reflect all publicly available information concerning securities. The investors would be left to fend for themselves. the managers of firms are obliged to "worry" about the nature of their capital structures and dividend policies. borrowing costs. Again. it would be irresponsible to conclude that those assumptions necessarily reflect reality. to the extent that individual investors cannot borrow on the same terms as firms or cannot easily dispose of capital stock in the absence of dividend payments. If all corporate managers presume that capital structure and dividend decisions are irrelevant. if our concern is for the well-being of investors. the entire burden of determining optimal strategies is thrust upon the investors. Similarly. price changes in efficient markets behave as random walks over time. being paid. 11 Also. The actual outcomes here would depend on the risk and return preferences of managers. security prices adjust rapidly and unbiasedly through the reactions of investors to any newly released information. These possibilities would seem crucial. managerial sell interest would tend towards no dividends. Thus.100 James O. if job security were of paramount importance to most managers. While it is comforting to assume that investors have similar leverage risks and borrowing costs as corporations and that they exist in a world free of institutional restraints. After all. are also cited as significant imperfections that might encourage firms to use smaller amounts of debt. Their risks of leverage. we would expect a preponderance of suboptimal levels of debt in most corporate capital structures. passive decision variable) ° The ethical implications of the Irrelevance Theorem seem clear enough. but they are usually dismissed as being unimportant. As a result. it also leaves us with a notion that dividend policy is just an irrelevant. A peculiar sort of managerial nihilism ensues if it is taken seriously. For example. and most of them have not overturned the hypothesis. In regard to capital structure. superior returns also cannot be earned by only reading annual reports or other published financial news. presumably by selling shares of stock whenever personal cash needs arose. In regard to dividend policy. some "strong form" tests have revealed that certain private.

The Ethics of the New Finance 101 information is not always reflected immediately in security prices because corporate officers and stock exchange specialists appear to earn superior returns on their investments. if there is some probability. In a similar vein. of enormously high returns on some few investments. a widespread acceptance of the normative implications of the Efficient Market Hypothesis by investors could lead to a major deterioration of security markets. 100] or that it "doesn't seem to work" [4]. By and large. albeit small. After all. Managers would be encouraged to not worry about the timing of security issues because no discernible patterns have been uncovered in the movements of security prices over time. of course. However. if there be any. to this curious paradox and dilemma will not be offered at this point. no one will be willing to do the analyses necessary ot make financial markets function efficiently. 409-11] There is. Perhaps it is not too surprising that proponents of this viewpoint refer to the stock market as a "game. That is. In this case. but instead. Investors would increasingly become interested in "long shot" gambles and would welcome security markets characterized by greater price volatility. but well worth winning. However. this normative perspective of the Efficient Market Hypothesis is ethically reprehensible. it might be positive. and if they heed the advice of Efficient Market adherents that security analysis is "valueless" [21. the world of the Efficient Market Hypothesis is a place where information is absorbed so quickly that the conventional forms of security analysis seem almost pointless for any individual analyst. Passive portfolio strategies would replace the attention given to individual companies in traditional security analysis. and quite possibly. managers would be discouraged from using deceptive accounting techniques because the "semistrong form" evidence suggests that the market will see through such attempts. at worst. This view treats investors as being essentially gamblers in a lottery. Prices would become more volatile and the volume of trading would escalate up sharply as investors substituted trading for analysis. security prices do not emerge from some neo-Platonic shadowy world." and thus will perform security analysis. they flow from the collective actions of analysts conscientiously and diligently reviewing all information as it flows into security markets. a peculiar sort of nihilism might again result. Also. Solutions. this "game" seems to be not worth playing. the efficiency of security markets would certainly be weakened if a significant number of irivestors decided that it is not a valuable activity. The implications of the Efficient Market Hypothesis in regard to managerial behavior seem relatively harmless. Clearly. given the preponderance of "weak form" evidence to date. the managerial behavior induced by the Efficient Market Hypothesis would seem to be. p. but that question is not created by the Efficient Market Hypothesis paradigm itself. Ironically. an ethical question imbedded in the superior returns earned by managers through inside information. [3. managers would be induced to disclose greater amounts of information because they would be assured that the markets would absorb it efficiently. which would presumably result in "better" market prices. but one possible resolution itself raises ethical implications. when scheduling the issuance of a security. Complete abandonment of security analysis is probably an extreme prediction. neutral. It is often suggested that investors will continue to try to "beat the market. the ethical implications of the Efficient Market Hypothesis are quite different when we turn to investors. there would be no point in waiting for the market to "rebound" or to worrying about whether the market will go higher. Aside from those latter exceptions. that greater price volatility could be achieved by a general . The superior returns earned by corporate officers suggest that they do in fact have valuable information to disclose. If all investors believe the hypothesis and accept its implications. In effect. pp. This would seem to be a benign result since the firm would base its financing activities on the timing of its real needs rather than the imagined optimal timing of financial market movements." Given the Efficient Market evidence that consistent superior returns on security investments are not possible.

the model trivializes the very existence of the firm. Certainly managers have an obligation to their workforce and to their community to preserve the life of their firm. Therefore. the volatility of the firm relative to the economy as a whole. in security markets. The other part. On the other hand. are quite willing to sell shares in large portfolios that are good approximations of market portfolios. so even this possibility appears to be a random choice. Those investors could create their own desired risk level through a spectrum of strategies which involve buying different combinations of risk-free government securities and the market portfolio or by borrowing to acquire greater amounts of the market portfolio. In this refined version of the Capital Asset Pricing Model. the Efficient Market Hypothesis paradigm threatens both the efficiency and the societal respectability of security markets if all investors take it seriously. The very "raison d'etre" of managers would seem to be at issue here. but a priori. "unique risk.. such as mutual funds. Thus. that obligation . Horrigan abandonment of security analysis by investors. However. Since unique risk can be eliminated so easily. the firm simply disappears into the gigantic market portfolio and the only risk that matters is the personal strategy that each investor pursues relative to the volatility of the economy as a whole. and a bit peculiar: managers should not be concerned with managing unique risks because their efforts will not be rewarded by the stock market. Given that bankruptcy is a unique risk. Among other things." which is also called "systematic risk. one market risk level seems as good as another. a premium for taking on that risk. the Capital Asset Pricing Model takes on a subtle twist. The central argument in the model is that risk should be separated into two parts. this advice would encourage managers to ignore such specific risks as bankruptcy. 12 The ethical implications of the Capital Asset Pricing Model seem very serious indeed. the Capital Asset Pricing Model presumably would encourage managers to be concerned with managing market risk. When combined wkh the previously mentioned notion that investors can pursue homemade financial strategies. This idea is not bizarre as it may seem at first glance because financial institutions. the only risk that matters is market risk. a portfolio consisting of all issued securities." embodies the risk caused by general factors in the entire economy that affect all firms. Granted. its implications for managers are quite clear. This diversification can be achieved remarkably easy because various studies have shown that about 15 to 20 randomly selected stocks will eliminate the unique risk in a typical portfolio. and all the other factors peculiar to a firm. by definition." which is also called "unsystematic risk. Whatever version of the Capital Asset Pricing Model is beheld. Market risk. An ultimate strategy for eliminating unique risk is to simply hold a "market portfolio. The rich insight of the Capital Asset Pricing Model is that unique risk can be eliminated by investors by holding diversified portfolios of securities. This advice is prone to a "reductio ad absurdum" argument because no one manager can control the movements of the economy as a whole.102 James O. local climate conditions. technological breakthroughs. Capital Asset Pricing Model Simply stated. including the companies issuing the securities. "market risk. Thus. the Capital Asset Pricing Model seems to be implying that managers should not waste their time managing any risk at all. One part. An individual firm might possibly structure itself in such a way that it would be more or less volatile relative to market movements. not all investors will necessarily desire a portfolio with a market risk level that exactly equals the average market risk." represents the risk caused by specific factors peculiar to an individual firm.e. investors will be unwilling to pay anyone." i. cannot be diversified away because firms cannot remove themselves from the economy. new competitors. internal cost structures. labor relations. the Capital Asset Pricing Model declares that investors pursue optimal combinations of risk and return when selecting investments.

Some monitoring of firms' unique risks must be performed. the set of return and risk combinations available to investors will be less attractive than otherwise. The investors are interested in individual firms only insofar as they affect the total market risk of a portfolio. but it is simply unthinkable that managers would choose to treat the survival of their firm as an outcome less important than the movement of their common stock relative to the stock market. where each investor diversifies into just enough firms to wash out unique risk. Investors may be able to diversify away unique risks. 17 The employees might be able to protect their interests by pressuring the managers to make low unique risk investments. if for no other reason than the market portfolio will become highly volatile if unique risks are not controlled by anyone. their only. 18 Thus. In the refined version of the Model. employees seem the least fit to perform that task. a peculiar sort of nihilism ensues. By refusing to be concerned about the unique risks undertaken by management. and any managers choosing to be unconcerned about those threats are simply acting unethically. Even if bankruptcy can be set aside from the model. a sort of "One World Financism" would result. but that strategy also leads to lower returns. that is. and for many workers. the notion that unique risks should be ignored still undermines the basic relationships that exist between an individual firm and all the parties involved in its inner workings. if they chose to ignore unique risks. "exercise" price. Their major. such as labor relations. onto the employees of the firm. Even in the less refined version of the Capital Asset Pricing Model. Once again. their very livelihoods are threatened by the Unique risks taken on by their firm. the Capital Asset Pricing Model contains the seeds of its own destruction if taken seriously. a result which penalizes everyo n e . even within the framework of the Capital Asset Pricing Model itself. the Model would encourage all investors to let "someone else" worry about the unique risks of all firms. but the Capital Asset Pricing Model would encourage them to concentrate exclusively on market risk. a profit by one party to an option is always an equivalent toss to the other In the case of investors. If all managers choose to ignore these factors. 16 It is not even clear that such a grand. the ethical implications of the Capital Asset Pricing Model for them seem similar to those induced by the Efficient Market Hypothesis. investors would have no interests in individual firms at all. for example. if not all. 15 In effect. Ironically. Options do not themselves create anything of value so they are essentially zerosum games. An option to buy an asset is a "call" and option to sell it is a "put. the Options Pricing Model assumes that all equities in a firm represent various options to buy or sell the firm's assets. A global. The composition and structure of the so-called "market portfolio" depends on the risk and return choices made by each and every individual firm. but in any case. an ethical issue of neglect still remains. The factors that determine the level of unique risk. in which no one is . Options Pricing Model Basically." These options give the holder the right to buy or sell the asset at a specific. but the employees of a firm cannot follow that strategy. investors are throwing most of the burden of unique risk assessment. 14 103 willing to be responsible for the necessary analyses of the expected risks and returns of individual firms. managers would also be behaving unethically from a societal standpoint. deductive system could work since "the market" is a conceptual fiction that has no real existence. External investors would have the necessary analytical skills and objectivity to perform unique risk monitoring. 13 Therefore. are also factors that determine the level of returns achieved by the firms. source of earnings is their wages from the firm and their major investment is the capitalized value of their work skills. But.The Ethics of the New Finance must be balanced with the need to earn an adequate return on the firm's investments. anonymous market portfolio and risk-free government securities would be their only investments.

ought to increase the riskiness of a firm's operations . known factor. In general. more specific contexts. and the stockholders have purchased a call option from the bondholders. They are tempted to play games at the expense of their creditors.the option to default . which they exercise when they pay off the debt. bondholders would seem to be extremely vulnerable to managers and owners aggresively pursuing the Option Pricing Model view of reality. Within that viewpoint. Financial decisions. the Option Pricing Model paradigm becomes more extreme as the firm's riskiness increases. 431] In other. perhaps through elaborate financial accounting systems. 211-12] Overall. they baldly assert that stockholders always have the option to "walk away" and leave the firm's troubles in the hands of its creditors.104 James O. Valuation models of stock options have shown that the value of an option is a direct function of short-term interest rates. The short-term interest rate generally has the least impact of the three factors determining an option's value. p. p. as a paradigm for analyzing the relationships between the various equity holders within a firm. it is important to note that the expected rate of return on the stock is not a determinant of option values. At the same time. The lenders have acquired the assets of the company. The view that stockholders party. Since the time left to the expiration of the contract is a given. such as dividend policy and capital structure. They suggest that only "out-and-out crooks" would play those games in normal circumstances.is the value of a put on the firm's assets with an exercise price equal to the promised payment to bondholders. Indeed. and the volatility of the rate of return on the stock. In that regard. the limited liability granted to stockholders can be considered put options held by the stockholders to avoid the effects of default on debt. Horrigan because increased volatility of earnings will increase the value of their call options. by serving as hedging and arbitraging devices. 389] These "games" consist of deliberately making high risk decisions with a small chance of a big payoff because the creditors will absorb most of the possible losses. As Brealey and Myers put it. the crucial unknown factor is the volatility of the rate of return on the stock." [6. volatility of stock returns emerges as a major determinant of financial behavior. however. it may well lead to somewhat dubious behavior. the Option Pricing Model is relatively innocuous. [6. that is. all common stocks of firms that have debt in their capital structure can be considered call options. Options can contribute to the efficiency of markets. all of which works to the disadvantage of the bondholders because options are essentially a zerosum game. is expected. As a vehicle for analyzing option markets." The usual expectation is that the bondholders will protect themselves from the vagaries of managers acting through the Option Pricing Model paradigm by writing protective covenants into bond contracts which restrict the manager's actions. pp. Thus. "the value of limited liability . however. [6. but the Option Pricing Model itself certainly does not contain any guidelines that would tell managers when they are acting as "lawabiding citizens" and when they are behaving as "criminals. p. the Options Pricing Model suggests that the optionholders. 268] Also. creative strategies. can be restrained and monitored at a moderate cost. the stockholders. but real decisions involving production and investments would be quite difficult to monitor and too much restraint would probably inhibit managers from pursuing flexible. [26. as was the case in the Capital Asset Pricing Model. But. In times of financial distress. These protections are probably imperfect. extensive monitoring of the firm's behavior. Brealey and Myers predict the following: Stockholders are tempted to foresake the usual objective of maximizing the overall market value of the firm and to pursue narrower self-interest instead. The ethical implications of the Option Pricing Model seem quite serious for both the manager and the investor. time left to the expiration of the option contract. the standard deviation of percentage stock price changes over time.

among others. Any strategy by stockholders that is built upon the premise that they will benefit from the direct losses of the bondholders is highly unethical. seep into financial management textbooks. widespread distrust of firms by creditors will be the inevitable consequence. and its ultimate resolution into financial theory is not all that obvious at this point. trivializes bankruptcy of the firm. We seldom fall into the trap of characterizing the wheat or stock market as an individual. and it is just beginning to This view that the firm is mainly a set of con- . However. managers. Thus. 2° While I do not intend to be critical of the use of option markets to make securities markets more efficient. But. to the set of contracts that define each firm. the various parties contend with each other for their rights. workforce. when joined to the Capital Asset Pricing Model. i. albeit its somewhat unfinished state. In effect. It is a thoroughly immoral view of finance. including the owners. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals . is not susceptible to a simple. [17] In this viewpoint.. In this sense the "behavior" of the firm is like the behavior of a market. These diverse parties form into "teams" through contractual agreements because they recognize that their welfare depends on the success of their team in competition with other teams. The only gains to stockholders that can be ethically justified are those arising out of the creation of real value. which Kant himself anticipated in his borrower example cited above.e.. the outcome of a complex equilibrium process. The ethical implications for the stockholder investors are much the same. 311] Agency Theory Our last component of the New Finance. Debt capital will become extremely costly and financial transactions will become heavily laden with legal restrictions and accounting requirements. within the firm. 19 The firm just represents a "crap shoot" on a "lottery ticket" subsidized by creditors and employees. unifying theme of Agency Theory is that the firm is simply a legal artifice which serves as a "nexus for contracting relationships" among the various individuals who are associated with a firm. and creditors. the use of an options paradigm in the internal decisions of a firm would be an odious practice.. In particular. The general. the center of attention switches from the firm. as such. Jensen and Meckling. nonetheless. Agency Theory depersonalizes the firm and perceives it as a dynamic struggle between groups with different needs and desires in regard to risk and return. Agency Theory. argue as follows: Viewing the firm as the nexus of a set of contracting relationships among individuals also serves to make it clear that the personalization of the firm implied by asking questions such as "what should be the objective function of the firm. no matter how rich its insights might be. all of which will seriously impair overall societal welfare. [17. the Option Pricing Model viewpoint. are brought into equilibrium within a framework of contractual relations.The Ethics of the New Finance 105 merely possess a call option on the assets of the firm and a put option in the event of a default is so utterly cynical it is difficult to even grant it the dignity of a critical analysis. brief description. The advice that stockholders can just "walk away" from financial distress actively encourages firms to court bankruptcy risks. in Agency Theory. through the production of goods and services. The firm is n o t an individual. but we often make this error by thinl~ing about organizations as if they were persons with motivations and intentions. If all managers and owners adopt the options paradigm. it has developed along a number of paths. the interests of the workforce and the community in the livelihood of the firm are cynically assumed away as concerns of little importance. It is relatively new compared to the other components." or "does the firm have a social responsibility" is seriously misleading. p. It is difficult to defend or accept such a viewpoint. Agency Theory. the firm is seen as a set of contracts between the various parties in the production process. warrants some attention here because it has the promise of being a vehicle for directly dealing with ethical questions in financial management. Also. Again. in their seminal article.

without the crystallization of interest about a single purpose conscious in the minds of a group of human beings. The managers may simply avoid the trouble and effort required to search out new profitable investments. but it would tempt the managers to give false signals. suboptimal risk and return strategies for the firm. and it really has not yet shown up as a source of normative advice in financial management textbooks." such as the dividend policy or capital structure adopted. which would clearly be impossible.." and the managers. potential conflicts between the principals themselves.the association of human beings.. It is. an issue touched upon here in the Option Pricing Model discussion above. However. there would be no occasion of the members of the group to go through the steps of complying with the outward forms prescribed by the state in order to obtain the name of a corporation. the "principals. it will bear watching in the future. 270-72] As mentioned above in the discussion of the Option Pricing Model. but the second one would seem to be potentially much more serious. How much nicer it would be if we could return to the original notion of a corporation promulgated by Dewing in one of the original works on business finance: . pp. pitting agents against principals and principals against principals as perpetual adversaries. presumes that markets cannot entirely eliminate agency problems and envisages the development of elaborate restrictive covenants in debt contracts. and they may adopt low risk levels to avoid the anxiety created by higher risk strategies. Resolutions of these conflicts can be costly and can significantly reduce the total value of firms and the values of specific equities. which is of interest here. agency theory raises more questions than it answers at this point. Also. However.. However. financial decisions do seem a somewhat cumbersome way to pass on signals about the firm. bound together in order to achieve a purpose. The predicted resolution of agency costs has developed along two lines. then. complete protection through covenants and monitoring systems would be extremely costly. This divergence takes two forms. 22 Thus. the "agents. The managers have an incentive to consume perquisites out of the firm's resources for their own personal benefits. emphasizing the litigious conflicts that will arise among the parties to a firm. A careful trade off between monitoring costs and benefits would have to be made. Tying managerial compensation to financial signals would seem a promising way to pry more information out of managers. These agency conflicts are further exacerbated by the informational asymmetry that exists between the agents and the principals because the managers possess considerably more information than other groups. have been considered. It is this community of tractual links between individuals seems rich with possibilities if ethical concerns are considered an integral part of the set of contracting relationships. Agency Theory has developed along legalistic lines so far. [26. if it continues on its present somewhat legalistic path. and extensive monitoring systems developed by owners or financial intermediaries. The first approach simply asserts that the managerial labor market will discipline managers to behave efficiently and that the continuous competition between managers within firms will cause them to monitor each other's performance. and they have a tendency to pursue easier. it could make a very positive contribution to finance theory. litigious view o f financial relationships." Also. The first agency problem has received the most attention.106 James O. [ 11] The second approach. Virtually every decision would have to be covered and monitored. the stockholders and bondholders. is the fundamental and teleological basis for the coming into existence and the continuing existence of a corporation . the essential reality of any corporation: that a group of human beings propose to associate themselves together in order to work toward attaining their common purpose. it raises the ethical danger of creating a very contentious. management compensation . 21 Agency costs arise because the managers' incentives diverge from those of the owners. Agency t h e o r y has concentrated on the conflicts that might arise between the owners of firms. 23 If ethical dimensions are woven into it.. Horrigan schemes tied to financial "signals.

it is time to return our emphasis to the workings of the firm rather than the workings of financial markets. and it is probably time to expand our focus in finance accordingly. They are also unconcerned about the risks facing the firm. somewhat akin to accountants. we should give more attention to the financing needs growing out of investment and production decisions. New types of monetary reward systems may have to be devised to encourage the necessary analysis. so it is here to stay. detached portfolio investor with no . Disequilibria probably abound in the real world. and they most certainly should not be assumed away. but they certainly show up somewhere. However. A cool. the corporation would be a legal form without substance. Fourth. Survival of the firm comes to mind immediately as a financial objective that perhaps deserves equal ranking. and carefully constructed agency relationships. and they are not encouraged to engage in any analysis. These kinds of considerations are obviously general and openended. Ecological harmony of the firm with its physical environment is another type of objective warranting the same ranking. cash flow forecasting. suggests that unique risks do not matter because they do not show up in market returns. Finance can help them achieve that purpose by developing powerful tools for capital budgeting decisions. the overall ethical result is a pervasive nihilism. Second. and they cannot be developed further here. the corporate world in the New Finance is a place where the firm can select any operating and financial strategies that it wishes. bankruptcy predictions. and finally. First. and so forth. to promote the volatility of returns at the expense of creditors. For example. we can hardly ban them in some sort of intellectual Luddite fashion. other than selecting a homemade risk level for a portfolio. we ought to consider emphasizing different human qualities in finance. Fifth. 25 Firms exist to produce products and services. If all of the inhabitants of this world take the normative recommendations of the New Finance seriously. for example. pp. The managers are unconcerned about the needs of the investors. we ought to consider demoting market returns to a lower status as an objective. clever option positions. Relaxing the various assumptions of the New Finance will allow for an analysis of those disequilibria. It is in danger of collapsing in on itself if everyone chooses not to perform the necessary analyses to keep financial markets efficient. about which the corporation is formed. we should recognize that much of the superstructure of the New Finance is built up in equilibrium models. Clearly. we should return to a greater emphasis on the financial aspects of "real" problems. In effect. the world of the New Finance is not a nice place ethically. regardless. or to at least make it equal to certain other objectives. The New Finance is a reservoir of powerful ideas in a positive. there is certainly more to life than market returns. 4-7] 107 Recommendations and conclusions In general. productivity analyses. or perhaps a corps of professional analysts will have to be created.The Ethics of the New Finance purpose which creates the focal center. The Capital Asset Pricing Model. shared by the group of individual human beings who wish to cooperate in order to attain this common purpose. The investors are not interested in individual firms. the underlying bases of the Irrelevance Theorem or the Capital Asset Pricing Model weaken if significant numbers of investors or employees cannot pursue optimal homemade strategies. 24 Third. even to the point of trivializing the possibility of bankruptcy. They are encouraged. who would take great intellectual pride in keeping financial markets efficient even though their monetary rewards were somewhat modest. and the investors will respond immediately through a combination of homemade portfolio diversification. These types of possibilities deserve more attention. we should explore the process by which the grand equilibrium of the New Finance is achieved. But. however. equilibrium theoretical setting. That is. if anything? Since we are dealing with the ethical implications of paradigms. what can be done. and without this community of purpose. [8. and it is time to turn our attention to those matters.

stewardship. a I am admittedly. 10 Van Horne [26." for lack of an official name. or do we w a n t to m a x i m i z e virtue subject to the c o n s t r a i n t s o f s a t i s f a c t o r y risk and return positions? Notes * I wish to thank my colleagues John Freear. If not. 7 Other ethical maxims are possible. portfolio analysis approach can also affect managerial behavior in another way." 11 Fruhan [15] also argues that "value transfers" within a firm between existing equityholders might be achieved by "finding or creating potential imperfections in the securities markets. A bizzare manifestation of this approach is the recent development of stock futures markets. T o p a r a p h r a s e B o u l d i n g s o m e w h a t . p. you keep it. all of the University of New Hampshire. is to make the world a decent place to live in. He states that "it reduces the art of management to a rather simple set of choices. and Dwayne Wrightsman. Fred Kaen. but the other parts are titled by their usual names in the literature.108 James o. We o u g h t to r e e m p h a s i z e s o m e o f the older virtues like pride o f o w n e r s h i p . p. the production of a product of service. the risk-return level of the market portfolio will lie on a less desirable "efficient frontier" if everyone ignores. is generally unaware of the operating implications of the New Finance. 12 Brose." 16 Ozar [23. as follows: t h e utilitarian principle. and the "TV test. Kant's categorical imperative. Horrigan ideas to the subject of business ethics. He claims that a broad gap in both paradigms and methodologies exists. He envisages that decision makers might operate individually according to morally acceptable rules and in a moral manner but be completely unaware that their collective behavior results in an immoral act by the corporate entity. I am content to accept the traditional notion that a business fulfills that responsibility by producing a quality product or service at a satisfactory profit. Kant himself used a finance example to illustrate his categorical imperative. 313] concludes "In final analysis. and if possible. 1 Findlay and Williams [14]. equilibrium based theory poses for a subject that requires normative arguments. researchers on both sides often do not realize they are analyzing the same phenomena. much less the ethical implications. which Business Week [24] describes as "a hot new world" where "investors are able to play the market without owning a share. 14 In other words. 6 For interesting discussions of the relevance of Kant's . His observation may well explain why the normative implications of the New Finance have received so little attention. the golden rule. including businesses. 40]. [SJ do we w a n t to optimize risk and r e t u r n subject to the c o n s t r a i n t s o f m o r a l i t y . you sell it. I am indebted to them for many useful insights. of course. deal with the problems that a positive. interests o t h e r t h a n overall risk level is c e r t a i n l y n o t o u r u l t i m a t e version o f an ideal financial person. He argued that a person who needed to borrow money but knew that he could not repay the loan should not borrow because loan funds would dwindle if every borrower behaved in the same fashion. p." My own position is that the social responsibility of any organization." s I am using Donaldson's [9] meanings for "deontological" and "teleological" here. Laczniak [20] lists five maxims that managers might find useful for operational decisions. 1s The ultimate effect of encouraging investors to hold only a market portfolio is to encourage them to own no securities whatsoever. passing up the opportunity to evaluate the New Finance in the light of the vast literature on the "social responsibility of business.unique risk factors. for their helpful comments. observes [7] that a CAPM. If the current performance of a company meets your corporate objectives. and intentionally. 9 Miller [22] has argued that different clienteles of taxpayers exist and that supply-demand interactions between those clienteles and corporations will arbitrage away any marginal tax benefits for a corporation." s Interestingly enough. See [19. Allen Kaufman. in their excellent critique of the New Finance. and as a result. 2 Bettis [3] suggests that at least one discipline. I am indebted to my colleague Dwayne Wrightsman for the title "Irrelevance Theorem. a better place to live in. we are not able to state whether or not dividend payout of the firm should be more than a passive decision variable. President of Technology Consulting Group. see [1] and [27]. and yes." He goes on to argue that such a viewpoint overlooks the real end of a business. the professional ethic. 299] makes a similar argument in the context of a corporation. but perfect labor mobility is clearly a rare phenomenon. ethical c o n c e r n . 4 The first part is titled the "Irrelevance Theorem. and Jan Landwehr for suggesting the paper in the first place. 13 Perfectly mobile labor forces could deal with the risk of bankruptcy by moving on rapidly to new jobs. strategic management. Inc." This possibility would worsen the problem here.." Jensen and Smith [18] recently dubbed the theorem as the "Irrelevance Proposition.

1979). Brealey. and Bowie. References 109 [1] Beauchamp. Kenneth E. [2] Bernstein. pp. Boulding and W. However. those two groups have recently experienced situations in which corporations have used bankruptcy as a way to escape debts owed directly to them.S.. 24 See Bernstein [2] for a thoughtful discussion of the need for analysts to keep markets efficient. and Jensen.J. Industry'. Inc. 54-57.: 'A Positivist Evaluation of the New Finance'. as in the case of Manville Corporation. Norman E. FinancialManagement 9 (2). Arthur Stone: The Financial Policy of Corporations (5th ed. To my knowledge. The Academy of Management Review 8 (3). 1965. Journal of Law and Economics 26 (1983). They argue that it is an "ill-defined residual interest" that does not readily lend itself well to contractual arrangements that would adequately match the "risks assumed with the rewards achieved. 301-325. 406-415. 1982). N. See [25].: 'The Rise of the MBA and the Decline of U. they also shift this risk to the firm's customers.C. and they have not seemed inclined to take on an ownership role. and they probably represent the future directions Agency Theory will take. 1983. 17. Inc. Corporate Strategy and Public Policy: Three Conundrums'. 284-85] for a very thoughtful discussion of this problem. 1980.: 'Modern Financial Theory. Journal of Political Economy 88 (2). Donaldson. pp. 1953). Fischer: 'Implications of the Random Walk Hypothesis for Portfolio Management'. 1981). Inc. Brose.: Prentice-Hall. 23 A pair of articles [12. pp. 13] by Fama andJensen deal with the ways firms are legally organized in light of Agency Theory. 385). 288-307. Allen Spivey. Eugene F. Inc.: 'Random Walks in Stock Market Prices'. M. Richard A. N. Linear Programming and the Theory of the Firm (New York: MacMillan and Co. Michael E.: 'Agency Problems and the Theory of the Firm'. Eugene F. Michael C. and Destruction of Shareholder Value (Homewood. Ill. Fruhan. 7-17. Application and Interpretation (Rev.: 'Agency Problems and Residual Claims'.E. Fama. up to now. p. Fama.. p. Dewing. whether the assumption content of such an analysis does not in fact eliminate the real problems to be solved in real world firms. employees are in fact a very large investors group in their own right because of their ultimate ownership interests in pension funds and group insurance funds.: Richard D. Journal of Law and Economics 26 (1983). 1960). 21 Using agency theory as their basic analysis. p. pp. 2s See Vickers [28] for a very rigorous presentation of this viewpoint. such as union contracts. pp.: Prentice-Hall. Tom L. real capital intensity. Jr. 14-23. pp... Black. E... 55-58. Stewart: Principles of Corporate Finance (New York: McGraw-Hill.: 'The Present Position of the Theory of the Firm'. 327-349. Marketing News 17 (16). 71-76. and degree of centralization of authority.. Irwin. i8 Ironically. Bettis.The Ethics o f the New Finance 17 tn some cases. 121] makes the interesting point that "an organizational agent exhibits his ethical commitments as much [perhaps more] in the procedural controls he places on his goal selection as in the goals selected. William E. pp.: Financial Strategy: [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] Studies in the Creation. The Ronald Press Company.: Financial Statement Analysis: Theory. Eugene F. Williams and Findlay [31] go so far as to propose that common stock be eliminated from corporate finance.: 'Separation of Ownership and Control'. Financial Analysts Journal 21 (5). and Jensen. Leopold A. 19 Interestingly enough. Fama. choice of managers. Michael C. Irwin. Kenneth E." 22 Goodpaster [16. and Williams.. pp. pp. therefore. IlL: Richard D. As he states it (p. ed. Fama. Inc. . Richard and Myers. pp. Financial Analysts Journal 27 (2).: Ethical Theory and Business (Englewood Cliffs. These articles contain many useful normative insights. in particular the determination of the actual factor mix. 13. 1980. 20 See Fruhan [15.: Homewood. they have turned over the management of those funds to trustees and institutional investors. 1971. in the cases of Continental Airlines and Wilson Foods Corp. "it can reasonably be asked. 1978). Boulding. Eugene F. 1979).J. Transfer. 1983. Thomas: Corporations and Morality (Englewood Cliffs. Findlay. pp." He goes on to say that this process will reflect itself in such controls as selectivity of information gathering. and thereby the implied risk class of expected income streams. such as regulated public utilities with "bad" investments in nuclear power plants. or consumer damage suits. 16-22. he is the only author who has raised this ethical issue.

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