The Firm’s Legal Form

Business firms usually take on one of three legal forms: proprietorship, partnership or limited
liability corporation. A proprietorship has a single owner. An example is the owner of the nearby
chai stall. If the income-tax department can induce him to file returns, his business would be listed
as a proprietorship. In a partnership, on the other hand, two or more persons decide to go into
business together. Examples are accountancy firms. The third type of organization is the limited
liability corporation, where stakes in the ownership are sold as shares. In many corporations,
frequently there are lakhs of shareholders, each holding only a few shares in this particular
company. The shareholders do not themselves run the company. They elect a Board of Governors
which in turn appoints managers to run the firm on a day to day basis.

In proprietorships and partnerships, owners are generally the managers and look after the operations
of the firm. In contrast, shareholders in large corporations often have neither the willingness nor the
ability to manage the firm. The major advantage that the corporation possesses over the other two
forms of business is that of limited liability of shareholders. If the firm goes bankrupt, the
shareholder loses only the face value of the share. Beyond that, she is not liable for the debts of the
company. However, in proprietorships or partnerships, the owners are fully liable for the debts of
the firm. Suppose that Vijay and Srija have invested, as partners, Rs. 25,000 each in a firm, which
goes bankrupt, leaving behind Rs. 150,000 in debt to creditors. Vijay and Srija will have to sell even
other assets (flats, cars, stereo systems, etc.) to repay the debt. But if they had bought stocks worth
Rs. 25,000 each in a limited liability corporation, they would be liable only for Rs. 25,000 each.

The Profit Maximization Hypothesis

The neoclassical view assumes that a firm tries to maximize profits. The firm is owned by the
shareholders. Shareholders get dividends on the shares they hold and these dividends come out of
profits. Hence, firms try to maximize profit.

We pose two questions here. First, even on theoretical grounds, are we sure that shareholders try to
maximize profits? Secondly, control in modern corporations rest with managers. What are the
managers' goals?

Shareholder Goals

Do the shareholders necessarily want the managers to maximize profits? The answer is no, if the
firm has any market power (i.e. it can affect prices by its actions) and if the shareholders participate,
even indirectly, in the markets that are affected by the operations of the firm. Thus consider four
shareholders of RR(Ram-Rahim) Inc., which has market power in both input and output markets.

Shareholder 1 is a consumer of the output of RR. If RR uses its market power to push up its profits,
it must do so at the expense of its customers who now have to pay more. If shareholder 1 is a major
consumer of RR's products but owns a relatively small fraction of its shares, he can be hurt by RR's
attempt to maximize profit more than he is helped by the distribution of the profits to shareholders.

Shareholder 2 sells factor inputs to RR. She may be hurt by receiving less price for her inputs more
than she is compensated by the increase in the dividends she receives.

Shareholder 3 has diversified his portfolio and holds shares in many other firms, some of which
compete with RR, some of which buy from RR and some of which sell to RR. To the extent RR
gains at the expense of any of thse other firms, 3 is made worse off.

Shareholder 4 buys nothing from RR, sells nothing to RR consumes none of the factor inputs of RR
and holds only shares of RR. But this shareholder does happen to consume a good that is
complementary to one of RR's factor inputs for some consumers. Then as RR holds down the price
of its factor inputs, it indirectly increases demand for the factor from other sources, which increases
demand for the complementary good, which bids up price of the complementary good, which makes
shareholder 4 worse off.

As an example, consider the following quote from The Economic Times of March 2, 1998 (FIs in
India hold stocks in many firms and the question being debated was whether they should sell out
when prices of stocks go up):

“As corporate India wakes up to a dawn of open offers, the role of financial institutions (FIs) is
under the microscope. Conventionally perceived as having sided with existing managements, FIs
are now hard-pressed to justify whether they are acting in the ‘best interests’ of their shareholders.

But support to an open offer is not as simple as selling shares and booking profit. FIs are suddenly
confronted with a Catch-22 situation : if the offer price is way above the ruling market price, the FIs
stand to gain by cashing out; the flip side of the coin is that the offer could place a heavy burden on
the balance sheet of the bidding company, in which the FIs might also be the major shareholders.

The India Cements bid for Raasi is a case in point: the FIs hold 35 per cent in India Cements
compared to 20 per cent in Raasi”.

We should also note that there might be a potential trade-off between long-term and short-term
profitability. A firm can report high profit figures by reducing R & D expenditures. This can have
serious implications for long-term profitability, particularly in industries like pharmaceuticals or
software where a continuous stream of new and improved products is necessary for the firm to
survive. U.S. industries have often been accused of taking such short-term view and thereby losing
out to Japanese counterparts over time.

Managerial goals

Berle and Means pointed out in 1932 the rise of the limited liability corporation and the increasing
separation of ownership from control in these enterprises. In the modern limited liability
corporation, the shareholders elect a Board of Directors, who in turn appoints the managers. The top
managers, rather than shareholders, control the firm and look after the day to day operations; and
their goals can be quite different from that of profit-maximizing. Even if the Board of Directors is
perfectly in tune with shareholder goals, it finds it impossible to keep watch on the day-to-day
running of the firm.

Alternative goals for managers have been suggested. Some writers have suggested that managers
pursue goals like sales maximization subject to a profit constraint, maximization of the rate of
growth, etc. Other writers say that the firm is too large, too complex and operates in too uncertain an
environment for any kind of optimizing behavior to make sense. Firms, rather managers, try to
attain satisfactory levels of performance for several variables. This is called satisficing behavior.

We now examine briefly the implications of assuming that the firm’s objectives reflect that of
managers rather than shareholders. In general, let us assume that the manager has an utility
function U =U(Q, ), where Q is the output sold, and  the profit. Higher production and sales
of the output means a larger organization which confers on the manager more power and prestige
(it can also mean tangible benefits like larger cars or apartments for the manager). Given the
demand curve facing the firm, there is a relationship between Q and  that can be represented by
T(Q, ) =0, or  = (Q). Even if the firm is controlled totally by the manager, the manager must
maximize utility subject to the constraint T.

For example, suppose that the demand curve facing the firm is P =a – Q (the firm is the only
producer of this commodity). There are no costs of production. Then  =PQ =aQ – Q
. When Q
=0, or Q =a, then  =0. Also, d/dQ =a – 2Q. Hence the slope of the  function is positive
when Q <a/2, reaches 0 when Q =a/2, and becomes negative when Q >a/2. This curve is
represented below.

---------------------- Q

The manager’s utility function U can generate a map of indifference or iso-utility curves that
show the different combinations of output and profit that can give the manager the same level of
utility. Depending on the shape of these curves, the manager will select a point on the profit-
output curve. As an extreme case, suppose that U =. Then the indifference curves are
horizontal to the Q-axis and the manager chooses Q =a/2 that maximizes profit ( =*). On the
other hand, if the indifference curves are convex to the origin, it is easy to see that the manager
chooses a point Q* which is larger than a/2, so that profit is not being maximized.

Baumol suggests that the aim of the manager is to maximize Q, but subject to a minimum profit
constraint. The manager must keep the shareholders satisfied by making sure that a certain level
of profit * is being made. This minimum profit constraint is then represented by a horizontal
line at the height *. The highest output subject to this constraint is Q”, which is again higher
than a/2.

Various arguments have been used to rebut such criticism of the profit-maximization hypothesis.
We now try to evaluate these.

The Survival of the Fittest Argument

If, over the long run, a firm does not maximize profits, then it is behaving inefficiently. Either it is
incurring unnecessary costs or failing to cash in on revenue opportunities. Other firms will be able
to undercut its price or provide better qualities, etc,. and erode its market share. In particular, in the
long run, product market competition forces firms to minimize costs. As part of this cost
minimization process, they have to take actions to raise external capital at the lowest cost. Hence
they are forced to adopt corporate governance mechanisms that provide assurance to investors.

This argument is, therefore, based on the disciplining effects of product market competition.

Market for Managers

There is a job market for managers, just as there is one for ordinary workers. A manager, under
whom firms perform poorly, will be able to command a lesser value on this market. This
argument ignores a number of things. First, even if a firm is performing poorly, it is difficult for
outsiders to assess whether the firm is doing poorly because it is being poorly managed or
because it is facing adverse market conditions. Secondly, a firm has a team of managers and it is
impossible to evaluate the contribution of each manager to the firm’s performance. One can only
think of one person in the organization who has to bear the notional responsibility for the firm’s
performance – the CEO.

Capital Market Controls

It has been argued that if the managers of the firm do not maximize profits, then the firm will be
taken over by some corporate raider and the managers will be fired. This threat of capital market
disciplining ensures that the managers do try to maximize profits. The argument goes something
like this: the inefficient functioning of the firm is reflected in poor share prices since poor dividends
are declared. A raider will then buy out the low price shares, gain control over the firm and replace
the existing team of managers by a more efficient team. As the performance of the firm improves,
so does its share price, and the raider can then make a profit by selling off the shares acquired earlier
at the new, higher price.

This argument of course assumes that the existing managers will react passively to the threat of a
takeover. Incumbent managers have been known to fight takeover bids tooth and nail if they
jeopardized their position. There are now a a number of defenses that managers can employ to foil
takeover bids.

Takeover Defenses

In the 1980s, North America and the United Kingdom witnessed a spate of hostile takeover attempts. In
response, a host of takeover defenses were generated by incumbent management.
White knight: when Mobil Oil attempted a takeover of Marathon Oil, U.S. Steel played the role of a white
knight, i.e., a friendly acquirer, by making a bid that Marathon’s management favored and finally accepted.
Poison pills: poison pills are devices aimed at reducing the worth of a company once it has been taken over.
One example is a clause requiring that huge dividend payments be made upon takeover – this can
significantly raise the cost of acquiring a company.
Scorched earth policies: these policies are those that deliberately reduce the firm’s value to the bidder, even if
it reduces value to shareholders in the process. One way to do this is to sell off key assets (which are called
crown jewels, because they are often the assets that make the company attractive in the first place) at greatly
reduced prices.
Golden parachutes: a golden parachute is a clause in the compensation contract providing for very attractive
benefits if a manager leaves after a control change. Incumbent managers thereby cushion themselves against
the risk of losing their current job should a hostile takeover occur.
Classified or staggered boards: in these boards only a fraction of the members are up for election every year.
It then becomes difficult for an outsider to gain quick control over the firm.
Supermajority rules: these require as much as 90% of the votes to effect change and have the same effect as
staggered boards.
Greenmail: this commonly consists of an offer by the existing management to buy out the shares acquired by
the raider at an attractive premium.

However, there is a much more subtle problem here. Suppose that a firm is being poorly run and
that its share price on the market is Rs.10. A raider appears and everybody knows that if the raider
succeeds in taking over the firm and making improvements, the share price will go up to Rs.20. To
take over the firm, the raider must buy up a majority of the stock. But can he do this successfully?
If it is known that the raider will succeed, any individual shareholder knows that the price will rise
to Rs.20 and hence will refuse to sell at less than this price. But if the raider must pay this price, he
can make nothing for himself by taking over the firm. If, in addition, there are costs to attempting a
takeover, the raider will surely back off. This problem of free-riding arises because each shareholder
who refuses to sell at or around Rs.10 is trying to free-ride on others: they are hoping that a
sufficiently large number of shareholders will sell their shares to the raider, thereby making it
possible for the takeover to happen, ultimately pushing up share prices to Rs.20.

The capital market story only makes sense if it can be assumed that the raider has an opportunity to
accumulate a number of shares large enough so that the improvements in their value covers the
costs of the takeover. But then raids that will result in minor improvements only will not pay for
themselves. Therefore while grossly mismanaged firms may be takeover targets, firms that are not
so poorly managed will not be targets, and we cannot expect profit-maximization to be achieved by
the discipline of takeovers. This line of reasoning points to the need for internal controls to align
management with shareholder interests.

Takeovers in India

The regulatory mechanism in India had till recently placed several hurdles in the way of
takeovers. The Monopolies and Restrictive Trade Practices Act of 1969 had placed various
restrictions on mergers, acquisitions and takeovers. Banks could not finance takeovers under the
regulations of the Reserve Bank of India. Again, the Government financial institutions that
control the bulk of shares in many companies had the power to ensure the success of takeover
bids to replace inefficient management. But any such move would have invited accusations of
political favoritism, so in practice no change in management took place even in grossly
mismanaged companies. Moreover, the board of a company had the power to refuse transfers to
a particular buyer, thereby making it almost impossible for a takeover to occur without the
acquiescence of the existing set of managers. The refusal to transfer the share could be on two
grounds: that the transfer was against the interests of the company or against the public interest.
Thus the scope for hostile takeovers (as against friendly takeovers) which can be viewed as the
capital market's instrument for enforcing efficiency, appeared to be limited. However, in spite of
the unfavorable climate, takeovers, mergers and acquisitions continued to take place. During
1988-92, 121 takeovers and mergers occurred.

In 1991, the Government omitted the relevant sections and provisions from the MRTP Act by the
MRTP (Amendment) Act. The need for prior approval of the Central Government for M & A
activities was abolished. The availability of cheap funds through Euro-issues (selling shares in
Europe) solved the problem of finance. Starting from 1988, the number of mergers and
acquisitions in India seem to be growing at a fast pace. In this context, the SEBI (Substantial
Acquisitions of Shares and Takeovers) Regulations, 1994, tried to create a climate in which
takeover activities could fulfill the function of effectively disciplining Indian firms.

The main objective of these regulations is to provide greater transparency in the acquisition of
shares and the takeover of companies through a system of disclosure of information.

Some of the highlights of the SEBI Takeover Code are:

 Acquirer holding more than 5% of shares in a company must disclose his shareholding to the
company and all stock exchanges where the scrip is listed.
 In negotiated takeovers, acquirer cannot acquire more than 10% shares in a company unless
she makes a public offer for another 20% of shares at acquisition price or average price of
previous six months.
 In open market takeovers, acquirer cannot acquire more than 10% shares unless she makes a
public offer at a price not lower than the highest open market price paid by her or average
price of previous six months.
 Any person other than the acquirer making a public announcement may within two weeks of
such announcement make a competitive bid for acquisition, subject to the same terms and
conditions listed above.
 Public offers once made cannot be withdrawn except with the prior approval of the Board
under conditions that make it impossible to carry out the offer, e.g. in the case of insolvency
or death of the acquirer.

The Bhagwati Committee was set up to review the Regulations and recommend changes. The
draft takeover code formulated by the Bhagwati Committee was released on 28 August 1996.
With the avowed aim of protecting the interests of shareholders, ensuring fairness, transparency
and equity, without discouraging the process of takeovers, the Committee sought to provide an
orderly framework of regulations in which takeovers can occur.

A number of recommendations of the Bhagwati Committee stand out. Acquirers can take a
company private, because it recommends doing away with the existing conditions of 20% public
holding after the offer. Acquirers have the option to buy out the remaining shares if the public
shareholding were to fall below 10% subsequent to a public offer. Another recommendation was
that an acquirer must deposit 10% of total offer amount in an escrow account. The amount will
be forfeited in case of default by the acquirer. Also, while retaining the trigger point of 10% for
making a public offer, the Committee recommends that consolidation of holdings by existing
management be allowed within a specified limit. Persons holding 10%-25% of shares may
acquire up to 2% shares in any period of 12 months and persons holding 25%-50% shares may
acquire up to 5% in any 12 month period without attracting the mandatory public offer
requirement (this is known as “creeping acquisition”).

Incentives in Organizations

Finally, one can try to align the interests of shareholders and managers by providing the latter with
appropriate incentives. For example, the manager can be given a bonus that is a straightforward
percentage of sales or profit. However, it has been argued that this promotes a short-term outlook in
managers: they try to inflate short term profit figures at the expense of necessary long-term

Another way of reconciling the aims of shareholders and managers is to offer the latter stock option
plans. These plans work on the following basis. The manager is given the right to purchase a certain
number of shares of the firm at a fixed price p any time within a given period (say, within the next
two years). The manager then has an incentive to increase profits and dividends, so that share prices
go up within this period. The manager can then buy her shares at price p per share and sell the
shares at the higher market price of p* and pocket the surplus p* - p per share. Incentives can also
be implicit. Poor performance is punished by firing the manager and good performance rewarded by
means of promotions and attendant perks.

The use of stock-option schemes has been widespread in the U.K. and the U.S. In the U.S., CEOs
have profited hugely from such schemes. In 2001 nine executives cashed in stock options worth
more than $100m, including Larry Ellison, the boss of Oracle (who got the biggest bounty,
$706m), and Lou Gerstner, the boss of IBM. While the evidence on the link between options and
performance is thin, options have focused managerial attention on shareholder value. They have
encouraged firms to drive down costs, even in the midst of a boom. They have also reduced the
costs of starting a business: young and talented employees can be persuaded to join with the
mere promise of future growth that stock options represent.

A study by Mercer Human Resource Consulting for the Wall Street Journal showed that in 2005
bonuses for the CEOs at 100 large American companies rose by 46.4%. The median bonus was
$1.14m. These are of course large suns of money. Moreover, there are plenty of instances where
the rewards seem unreasonable. Michael Eisner, for example, the controversial chief executive of
Walt Disney, who was almost booted out of the job by shareholders in 2004, nevertheless
received a bonus of $7.25m. However, the amounts paid as bonuses are still far smaller than
those that used to be paid under stock options.

Source: Economist, March 3, 2005. “Fat Cats turn to Low Fat”.

While incentives generally are sought to be provided through monetary rewards, some firms seem
to believe that the "working environment" plays an equally important in aligning management goals
with that of the firm's long-term objectives. Companies like HLL, Thermax, Marico and Mahindra
& Mahindra do not pay the highest salaries in the market, but still seem to have highly motivated
workforces. Some of the ways in which this high level of motivation is sustained and generated are
as follows:
 Training and rotation across functional areas - The first provides an incentive to stay on in the
job to increase skills while the second prevents boredom.
 Delegation - Giving freedom to employees (often termed "empowerment") induces innovation
and a sense of responsibility.
 Transparency - Transparency relating to sharing of information about the company seems to
generate a sense of belonging.
 Trust - The idea is to foster self-accountability among employees, thus lessening the need for
monitoring and supervision.