BRITAIN´S STRATEGIC CHOCOLATE DILEMMA / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Britain’s strategic chocolate dilemma

By Martin Wolf

Published: January 28 2010 20:19

Briefly, during the takeover bid for Cadbury by Kraft, I thought the UK might proclaim a “strategic chocolate” doctrine. Fortunately, that did not happen. Less fortunately, if history is any guide, the takeover of Cadbury is quite likely to be a flop. If so, the winners will be the shareholders of Cadbury, the advisers for both sides and those who arranged the loans. The right question, then, is not about chocolate. It is about the market in corporate control itself.

For high priests of Anglo-American capitalism, this question is heresy. They would insist that shareholders own the business and have a right to dispose of their property as they see fit. They would add that an active market in corporate control is an essential element in “shareholder value maximisation”, on which an efficient market economy rests. Yet, after financial markets have gone so spectacularly awry, the question whether companies should be left to the markets is being raised.

The response to the first of these arguments is that ownership rights are never absolute. In fact, the ownership of companies by their shareholders is highly diluted, as my colleague, John Kay, has noted on several occasions.

Shareholders enjoy limited liability. As a result, the responsibility they bear for the malfeasance or incompetence of management is highly circumscribed. The claim of shareholders is solely on the residual income of the company. But, since shareholders can diversify their portfolios with ease, their exposure to the risks generated by an individual company is far less than the exposure of workers with firm-specific knowledge and skills. Shareholders lack the ability to assess or monitor a company’s performance. If they are able to sell their shares in liquid markets, they do not have incentives to do so either. Failures of corporate governance in widely held public companies are, it follows, inevitable.

As problematic as the notion of shareholder ownership is the recommendation to maximise shareholder value. Harvard university’s Michael Jensen has argued that “in the absence of externalities [and when all goods are priced] social welfare is maximised when each firm in an economy maximises its total market value”. This is a statement of the efficiency properties of perfect markets. But markets are imperfect, not least financial markets. They can lead managers in what prove to be wealth-destroying directions: just consider the stock market bubbles in Japan in the late 1980s and the US in the late 1990s. Companies exist to provide valuable goods and services to their customers. The market’s evaluation of profitability may well be a defective measure of progress towards this broader objective.

This general point has particular force for the market in corporate control. As we have known since the Nobel-winning work of Ronald Coase, companies exist because hierarchies are superior to markets. One reason for this is the cost of defining and monitoring specific contracts. Instead of detailed contracts, long-term relationships based on trust need to emerge inside businesses and between businesses and suppliers. But the knowledge that management may be ousted by opportunistic buyers could well act as a disincentive to forming such relationships in the first place. Everybody will then become an opportunist. If so, the companies likely to thrive are those for which these relationships are unimportant. An active market in corporate control might distort a country’s comparative advantage and even undermine its long-term success.

Evidently, there exist countries with highly successful companies – Germany and Japan come to mind – that do not permit an active market in corporate control. For the Japanese, the idea of selling a company over the heads of its management is as ridiculous as that of selling their mothers. In these eyes, a company is a social institution with wide obligations, particularly to long-term employees, not an entity to be bought and sold.

Yet shareholder value maximisation and the market in corporate control also bring benefits: markets may be imperfect, but they are arguably the least bad measuring rod; shareholder value at least gives a company a clear criterion; and the takeovers liberate assets from the hands of incompetent managers and so should frighten them into action.

Since a market in corporate control will never be a global norm, we enjoy the benefit of learning from a natural experiment. There is no theoretically correct answer, but we can learn from the corporate performance of countries with divergent approaches.

Where does this leave the UK? A shift to more restrictive British takeover rules is most unlikely to help. We need only think back to the dismal performance of UK companies in sleepier times. If that means we have to swallow the takeover of a Cadbury by a Kraft, so be it: strategic chocolate should not be on the agenda.

Companies do not have to go public. If they do, they live by the markets’ judgment. In the UK, shareholders rule.

Copyright The Financial Times Limited 2010.