The Divine Right of Capital

The Divine Right of Capital: Dethroning the Corporate Aristocracy, by Marjorie Kelly, editor and publisher of Business Ethics magazine was published in 2001. The premise is that while the American Revolution did away with the divine right of kings, the rise of corporations has resulted in the evolution of an economic aristocracy of the wealthy. The foundation of this aristocracy is the corporate mandate to maximize the return to stockholders.

Kelly uses extensive metaphor to compare corporate stockholders to 18th century French and English nobility who did no work but derived their income from their lands worked by serfs, and compares corporate employees to the peasants and serfs whose labor produced the income which flowed to the nobles.

The metaphor is strong, but the reasoning is flawed. The basis for the comparison of stockholders to nobility is that they (she says) have the right to extract wealth from the corporation in return for nothing.

Equity capital is provided by stockholders when a company goes public, and in occasional secondary offerings later. But in the life of most major companies today, issuance of common stock represents a distant, long-ago source of funds, and a minor one at that. What’s odd is that it entitles holders to extract most of the corporation’s wealth, forever.

Equity investors essentially install a pipeline, and dictate that the corporation’s sole purpose is to funnel wealth into it. The pipeline is never to be tampered with — and no one else is to be granted significant access (except executives, whose function is to keep it flowing).

The truth is, the commotion on Wall Street is not about funding corporations. It’s about extracting from them.

In other words, unless they by stock directly from the corporation, stockholders do not invest in corporations, they invest in the stock market and the corporation derives no benefit from the "investment". What's more, because the corporation must maximize the return to the stockholders, it does so at the expense of the employees who are directly involved in producing the wealth that is being distributed.

Unfortunately, she then refutes herself a few pages later by saying:

Stockholders are theoretically said to have a right to all of [the profits], and in an earlier age this was apparently true....But today stockholder get only a piece of earnings (about a third) in dividends. The rest is kept as retained earnings, to be used by the corporation.

There is the continual investment that the stockholder makes. The stockholder is not taking all of the value out that he/she is entitled to. Retained earnings not paid out to stockholders is reinvestment being made by the stockholders. By Kelly's own example, the average stockholder reinvests twice as much as is taken out. But this is only for companies paying dividends. For companies that pay no dividends, the stockholders take nothing out of the corporation as they receive none of the profits. Because of this 100% reinvestment, the value of the corporation grows and so does the value of each share.

Yet Kelly says:

Equity represents the actual capital stockholders contributed when they purchased new shares. And the retained earnings portion of profit is added to that equity each year. Thus by the magical closed loop of accounting, equity grows year after year, while stockholders never contribute another cent.

No, not another cent, just two-thirds of the reward they are entitled to (twice as much as they take out).

But why are stockholders entitled to all of the profits in the first place? Because they own the damn company! Yes. They really do.

If you own a company as a sole proprietor, you are entitled to 100% of the profits. If you take on an equal partner, you are each entitled to 50% of the profits because you each own 50% of the company. If you sell shares in the company, then each shareholder owns the percentage of the company represented by the shares of stock they own and they are entitled to an equivalent share of the profits. All of the shareholders (i.e. all of the owners) as a whole are entitled to all of the profits.

An owner of a business is entitled to the profits from that business for as long as he owns the business. If he sells the business, he is no longer entitled to the profits, the new owner is. Likewise, a stockholder is entitled a share (dividend) for s long as he owns the stock. If he sells his share to a new owner, the new owners has the same right to the profits as the original owner. And if he does not receive all that he is entitled to, then what he does not receive is a reinvestment. I don't know why that is so hard to understand.

Why are stockholders favored over employees? It goes to the issue of risk and reward which I discussed previously. Employees, since they receive a paycheck whether the company is profitable or not, trade their interest in future profit for a steady income. Stockholders take the risk that there will be no income unless the company is profitable and this risk commands a higher reward. Lets go back to retained earnings for a moment. In companies that do not pay dividends, and there are a lot of them, the stockholder receives nothing until he sells his stock to the highest bidder. If he has made a good investment, the earnings retained and not paid out in dividends will have increased the value of the corporation and thus the value of the stock. But if not, he will lose money. Is this gambling? Speculation? No more so than when a man builds better mousetrap and hopes to sell it. If people buy his mousetrap, he makes money, if not, he loses.

Another complaint Kelly has is the that employees are carried as an expense and this makes them a target of cuts when business is bad. I tend to agree with her to some extent here. Employees are more than an expense. Good employees are an asset and assets add value, they do not reduce it. Many companies recognize this and pay bonuses to employees when profits are good. Many new corporations, especially technology companies, pay employees in salary and stock options. Employees thus have a stake in the success of the company and are entitled to both share in the profits and reinvest in the corporation just like other stockholders. They are also entitled to sell their stock like any other stockholder and many do.

Of course, as we saw in the technology and dot-com bubbles, in companies that are not profitable, stock options may be the major component of employee compensation and employees get to assume the same risk as the stockholder. If the company does not succeed, they never get paid. And when they don't get paid, being a stockowner doesn't seem like such a good idea. The fact is, most employees don't want to assume risk, and wait for reward that may not come. they want a paycheck every two weeks. They want the check because the can't afford the risk. Investors assume the risk because they can afford to do so. And Marjorie Kelly doesn't like it.

Where does wealth come from? More precisely, where does the wealth of major public corporations come from? Who creates it?

To judge by the current arrangement in corporate America, one might suppose capital creates wealth — which is odd, because a pile of capital sitting there creates nothing. Yet capital-providers (stockholders) lay claim to most wealth that public corporations generate. They also claim the more fundamental right to have corporations managed on their behalf.

Wealth is created by the combination or labor and capital. Capital without labor creates nothing because there is nothing to work on it. Labor without capital created nothing because there is nothing to work with.

What do shareholders contribute, to justify the extraordinary allegiance they receive? They take risk, we're told. They put their money on the line, so corporations might grow and prosper.

Let’s test the truth of this with a little quiz:
Stockholders fund major public corporations — True or False?
False. Or, actually, a tiny bit true — but for the most part, massively false.

To the contrary, this is very true, as shown by her own example of retained earnings.

In fact, "investing" dollars don't go to AT&T but to other speculators. Equity "investments" reach a public corporation only when new common stock is sold — which for major corporations is a rare event. Among the Dow Jones Industrials, only a handful have sold any new common stock in 30 years. Many have sold none in 50 years.

Sorry, that does not follow. An owner of a business is entitled to the profits for as long as he owns the business. If he sells the business, he sells not just the present value of the assets, but the future value of the profitability of the business. To receive value now, future profitability is discounted and the new owner assumes who is buying the present value and future profits assumes the risk of failure.

An investor buys a share of a company. The investor becomes part owner. A part owner is entitled to a part of the profits. As an owner can sell a business, a part owner can sell his part. The new part owner is then entitled to the same part of the profits, including future profits. But by your own example, the stockholder rarely gets all that he is entitled to.

By her own description, stockholder are only paid 1/3 of the profits they are entitled to (as owners, they are entitled to 100%). So by your own description, stockholders are continually reinvesting in the corporation. Retained earnings are added to equity because that is what it is; it is an investment, just like the stockholder's initial investment.

The stock market works like a used car market, as accounting professor Ralph Estes observes in Tyranny of the Bottom Line. When you buy a 1989 Ford Escort, the money doesn’t go to Ford. It goes to the previous owner. Ford gets the buyer’s money only when it sells a new car.

Other than buying and selling, the stock market works nothing like a used car lot. This is a false analogy. When you buy a new car, you are not buying a share of Ford. When you buy a used car you are not buying a share of Ford. You are comparing apples and anthills---there is no analogy.

Similarly, companies get stockholders’ money only when they sell new common stock — which mature companies rarely do. According to figures from the Federal Reserve and the Securities and Exchange Commission, about 99 percent of the stock out there is "used stock." That is, 99 out of 100 "invested" dollars are trading in the purely speculative market, and never reach corporations.

Public corporations do have the ability to sell new stock. And they do need capital (funds beyond revenue) to operate — for inventory, expansion, and so forth. But they get very little of this capital from stockholders.

In 1993, for example, corporations needed $555 billion in capital. According to the Federal Reserve, sales of common stock contributed 4 percent of that. I used this fact in a pull-quote for a magazine article once, and the designer changed it to 40 percent, assuming it was a typo. It’s not. Of all capital public corporations needed in 1993, stockholders provided 4 percent.

Well, yes, critics will say — that’s recently. But stockholders did fund corporations in the past.

Again, only a tiny bit true. Take the steel industry. An accounting study by Eldon Hendriksen examined capital expenditures in that industry from 1900 to 1953, and found that issues of common stock provided only 5 percent of capital. That was over the entire first half of the 20th century, when industry was growing by leaps and bounds.

So, what do stockholders contribute, to justify the extraordinary allegiance they receive? Very little. And that’s my point.

Equity capital is provided by stockholders when a company goes public, and in occasional secondary offerings later. But in the life of most major companies today, issuance of common stock represents a distant, long-ago source of funds, and a minor one at that. What’s odd is that it entitles holders to extract most of the corporation’s wealth, forever.

Equity investors essentially install a pipeline, and dictate that the corporation’s sole purpose is to funnel wealth into it. The pipeline is never to be tampered with — and no one else is to be granted significant access (except executives, whose function is to keep it flowing).

The truth is, the commotion on Wall Street is not about funding corporations. It’s about extracting from them.

Once again, by her description, stockholders are only paid 1/3 of the profits they are entitled to (as owners, they are entitled to 100%). So by her own description, stockholders are continually reinvesting in the corporation. Retained earnings are added to equity because that is what it is--and investment, just like the stockholder's initial investment.

The productive risk in building businesses is borne by entrepreneurs and their initial venture investors, who do contribute real investing dollars, to create real wealth. Those who buy stock at sixth or seventh hand, or 1,000th hand, also take a risk — but it is a risk speculators take among themselves, trying to outwit one another like gamblers.

No, all stockholders assume risk for the corporation. As she has described, retained earnings are real investing dollars. Any stockholder that does not receive his full share of the profit is assuming the risk that the company will be unprofitable in the future and the investment as well as his interest in future profits for which he paid, will be lost.

It’s odd. And it’s connected to a second oddity — that we believe stockholders are the corporation. When we say "a corporation did well," we mean its shareholders did well. The company’s local community might be devastated by plant closings, its groundwater contaminated with pollutants. Employees might be shouldering a crushing workload, doing without raises for years on end. Still we will say, "the corporation did well."

One does not see rising employee income as a measure of corporate success. Indeed, gains to employees are losses to the corporation. And this betrays an unconscious bias: that employees are not really part of the corporation. They have no claim on wealth they create, no say in governance, and no vote for the board of directors. They’re not citizens of corporate society, but subjects.

Investors, on the other hand, may never set foot inside "their" companies, may not know where they’re located or what they produce. Yet corporations exist to enrich investors alone. In the corporate society, only those who own stock can vote — like America until the mid-1800s, when only those who owned land could vote. Employees are disenfranchised.

The employee does not put the value of his labor at risk. He exchanges it for immediate reward in the form of wages. Employees exchange risk for security. They do this because the do not want to take the chance that the company will not make money and their labor will be unrewarded. So they accept present value of the labor rather than wait for a share of the potentially greater value that results from the combination of labor and capital.

The employee can put his labor at risk. In some companies, employees accept lower wages but receive stock options. These options are not a gift, they are a recognition that the employee has assumed some risk in accepting a lower wage. This assumption of risk entitles the employee to a share of the future profitability of the company instead of just the present value of his labor.

Investors do not have to set foot inside a company to make their critical contribution: the assumption of risk. The initial investor takes the greatest risk, and generally, reaps the greatest reward when the stock price increases with the company's success. But as part of his investment, he is also entitled to a share of profits for as long as he owns the stock and the company is profitable. Later investors assume a lesser risk so they may not see as much growth in stock price. If the company pays dividends, they are entitled to those as a share of the profits. But if it does not pay dividends, they will have less reward. But again, for less risk.

We think of this as the natural law of the free market. It’s more accurately the result of the corporate governance structure, which violates free-market principles. In a free market, everyone scrambles to get what they can, and they keep what they earn. In the construct of the corporation, one group gets what another earns.

No, the investors earn their share of the profit by assuming risk. There are different levels of risk that can be assumed. Bondholders assume less risk and receive interest on the money they loan to the corporation. The interest reflects the risk they assume, but the loan is a liability and the bondholder is creditor who will be repaid before the stockholder's profit is calculated. Thus, the bondholder has a lower risk and a lower reward.

The employees assume little or no risk and accept payment for their labor. By assuming no risk, they are not entitled to a share of the profits, though they may be rewarded with bonuses.

The oddity of it all is veiled by the incantation of a single, magical word: "ownership." Because we say stockholders "own" corporations, they are permitted to contribute very little, and take quite a lot.

She really gets carried away with this idea that stockholders contribute little. Without stockholders, who would assume the risk? Employees don't want to do it because they can't afford to. They need the steady income. Only someone with sufficient cash reserves can afford the risk. And without someone to assume the risk and provide the capital, there would be no work for the employees.

What an extraordinary word. One is tempted to recall Lycophron’s comment, during an early Athenian slave uprising against the aristocracy. "The splendour of noble birth is imaginary," he said, "and its prerogatives are based upon a mere word."

But the risk assumed by the stockholder is real, not imaginary, and the reward for assuming that risk is well earned.

I could go on, but the rest of the book is more of the same. Kelly's style is pejorative argument. She assigns negative labels to that she wishes to demonize then uses the definitions of those labels to support her arguments. But she provides very little hard data to support her labeling. The term "stockholder" is used interchangeably with "monied class", but the majority of stockholders are not extraordinarily wealthy (you don't have to be rich to own stock, you just need to be willing to assume the risk). Kelly's appeal is to the emotion, not to the mind; she seeks visceral reaction, not reasoned thought. Two passages demonstrate this.

Shareholder primacy emerged from the ether in the mid nineteenth century when it was articulated by the courts. The basis for shareholder primacy is common law, judge-made law.

But common law is definitely not "judge-made law". Common law the "law of the commons", established through custom and practice and judicially recognized by the courts as legally binding. If shareholder primacy is based in common law, it is based in centuries of custom and practice and did not "emerge from the ether" at the whim of a judge. But Kelly wants us to believe that shareholder rights are something dreamed up by a judge to protect his rich friends. When common law is viewed correctly, it stands Kelly's theory on its head.

[Shareholder primacy] stems from the seafaring age, when persons jointly financed ships and sought to hold the operators accountable so money would not be wasted....One might add, parenthetically, that the custom of investor primacy once permitted piracy--as seafaring vessels were legally permitted to attack other ships and seize their cargo....One might suppose evenly modestly civilized thinking would have led us to carve out a "piracy exemption," saying corporations should maximize returns to shareholders, but they should avoid piracy. But we haven't gotten even that far yet.

Piracy was never legal, though some countries did not consider it to be illegal. It is one of the oldest crimes on the high seas. In times of war, private vessels are issued letters of marque which authorizes them to attack enemy merchant ships. These are privateers, not pirates. Congress is authorized to issue letters of marque in Article ! Section 8 of the US Constitution. But Kelly would have us believe that corporations loot and pillage on behalf of stockholders and since she has chosen metaphor as her vehicle, she created one. Here is an idea that emerged from the ether.

She has some ideas that might be worth considering if she did not illegitimize those ideas with her methodology. Her conclusions are as credible as the Salem witch trials and so are her ethics. From this, it is easy to see that Kelly is pursuing an agenda grounded not in ethics but in a socialist/communist ideology of class warfare. If one accepts her initial premise that stockholders only take profits from a corporation and put nothing into it, then the metaphor of a corporate aristocracy might appear to apply and the rest of her arguments are easier to follow (or swallow?) But if the premise is false (which she demonstrates by her own examples), then the rest of her arguments have no basis and the reader must constantly remind himself just what she is talking about. In the later chapters Kelly apparently assumes the reader has accepted the initial premise and provides no reinforcement. I suppose this is understandable--if you don't accept her metaphorical premise, further reading is a waste of time.

Reading this book was a challenge. I have read Nazi and KKK material regarding inferior races and the experience was like drinking Drano. Reading The Divine Right of Capital was not much different. Instead of an idea worth considering, she seeks to convey an ideology of class hatred under the guise of ethical conduct. Actually, Drano might be more palatable.