Faith Based Investing: are shares entitled to the residual?

Published date19 May 2009
Date19 May 2009
AuthorDaniel J.H. Greenwood
Daniel J. H. Greenwood
Shareholder dividends are ‘‘rents’’: they are paid out of a producer’s
surplus that, in a fully competitive market, would not exist. In any market
system, no one has a right to rents. Why, then, do shareholders receive
dividends? Most likely, share gains have been the result of the usefulness
of the share-centered ideologies in justifying a tremendous shift of
corporate wealth from employees to an alliance of top managers and
shareholders. This alliance now shows signs of breaking down, as the
managers learn they no longer need the ideological cover. Standard
accounts conceal the struggle over corporate surplus and the weakness of
shareholder claims to appropriate it. Recognizing that distribution of
corporate surplus is a political struggle is the first step towards a less
ideologically blindered discussion of how that struggle ought to be
This chapter is a heavily revised version of Greenwood (2006).
Law & Economics: Toward Social Justice
Research in Law and Economics: A Journal of Policy, Volume 24, 91–130
Copyright r2009 by Emerald Group Publishing Limited
All rights of reproduction in any form reserved
ISSN: 0193-5895/doi:10.1108/S0193-5895(2009)0000024009
Everyone knows that shares receive dividends because they are entitled to
the residual returns of a public corporation. Everyone is wrong.
Basic principles of market competition, applied to the actual law of
corporations, sharply contradict the conventional wisdom. First, share-
holders are not residual claimants in any legal or economic sense so long as
the corporation remains in existence. Second, standard economic theory
implies that shareholders should receive dividends only under noncompe-
titive conditions, and not often even then.
Standard accounts elide the problem by a number of mutually contra-
dictory rhetorical tropes, each seeking to portray payments to shareholders
as philosophic entitlements or market necessity. None stands up to serious
questioning. Instead, payments that corporations make to shareholders
result from the then-current economic and political power of the stock
market and, especially since the taming of the hostile takeover market, from
ideological victories in a multilateral struggle over corporate surplus.
Shareholder returns depend on shareholder power – both the soft power of
ideology and the hard power of law and the legally structured market – at
least as much as on underlying business success.
Moreover, the struggle is largely over rents – the surplus generated by
the corporation itself. Accordingly, if the current results are unattractive,
we can change the rules, modify the power of the various players, or
seek to persuade them to accept different views of their ethical rights
and obligations with no efficiency implications.
The distribution of rents
matters: if corporate returns go to shares, we may generate more invest-
ments but we definitely end up with far more inequality, short-term
outlooks, and tolerance of anti-social externalization; if returns go to top
managers, we reward entrepreneurialism but invite corruption; if returns go
to rank and file employees, they are shared most widely but there may be a
cost in lost flexibility; if returns remain inside the corporation, they may
contribute to growth or simply subsidize slack. But nothing in the nature of
the corporate form requires that the current distribution be viewed as a
sacred entitlement or a necessary consequence of our way of life.
On the standard economic view, shareholders contract to receive corporate
profits, which are the same as the residual, that is, what is left over after all
contracting parties have been paid their contract amounts (Brealey &
Myers, 1996, p. 364). This account is quite problematic.
Public shareholders are perfectly fungible providers of the most perfectly
fungible of commodities in our most competitive of markets. In a com-
petitive market, the price of a commodity should be its marginal cost.
Accordingly, shareholders should expect to be paid no more than the
marginal cost to the firm of retaining them. But corporate law provides that
shareholders have no right to corporate distributions at any given time –
shareholder contributions are permanent capital that the firm may retain
without further payment for as long as it deems appropriate. The marginal
cost of existing shareholders is therefore zero, and that should be the price
they can command in a competitive capital market.
Focusing instead on product markets, we reach the same conclusion. In
fully competitive product markets, any firm that paid shareholders a current
return would be uncompetitive: its costs, and therefore its prices, would be
higher than those of competitors that defer shareholder payouts. In less
competitive product markets, a firm might have disequilibrium or monopoly
profits. Still, it need not give them to shareholders at any given time. In a
system of rational maximizers, dividends would always be paid tomorrow,
and tomorrow would never arrive. Accordingly, under standard economic
pricing theory shareholders should expect no return.
Shareholders in public firms have no contractual or other legally
enforceable right to any payment at all. The corporation, acting by board
decision, determines in its discretion whether and when to pay dividends or
otherwise transfer funds to shareholders. Thus, dividends bear a certain
resemblance to bonuses or tips – an after-the-fact payment enforceable only
by custom, not law. Traditional tips, however, occur in personal service
markets where repeating personal relationships and reputational concerns
can enforce after-the-fact payments without recourse to contract; bonuses,
similarly, occur in multi-period markets where bonus payers have incentives
not to renege because disappointed recipients will quit (and employees have
sufficient market power to be willing to accept the risk that they will be fired
without full payment). In contrast, shareholders are both fungible and
anonymous. Standard explanations for the stability of tips or bonuses will
not work in this context. Instead, the usual economic models predict that
dividends as known should not exist.
Shareholders of closely held corporations, unlike publicly held ones,
actually control the firm and, like real owners, can use that power to simply
take any corporate surplus (disequilibrium profits) that may exist. There-
fore, closely held firms do not present the full dividend puzzle. In the era of
Faith Based Investing: Are Shares Entitled to the Residual? 93

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