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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.

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that part increasingly becomes accepted as utilitarian and pragmatic. Fourth, and finally, recommendations shall be offered as to how the New Finance should be approached in future developments in the subject of financial management.

a nexus for contracting relationships between stockholders, bondholders, managers, and other groups. Financial decisions spring from inherent conflicts between those groups, which are exacerbated by information asymmetry between the groups.

The New Finance In its present state, the New Finance consists of five major parts: the Irrelevance Theorem; the Efficient Market Hypothesis; the Capital Asset Pricing Model; the Options Pricing Model; and Agency Theory. 4 Each of these parts are theories in their own right, but they blend together, albeit loosely in some instances, into a grand theory of financial management. The backdrop, or perhaps the deus ex machina, linking all of these parts is perfect capital markets driven by a perpetual pursuit of shareholder wealth maximization. The Irrelevance Theorem States that, given the firm's investment policy, the general corporate decisions in finance, especially decisions involving capital structure and dividend policy, do not matter because investors will simply adjust their strategies to offset any disequilibria created by the corporate decisions. 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 a result, financial analysis will not necessarily yield superior returns to an investor. 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. Consequently, the only risk that matters is the volatility of a firm relative to the economy as a whole. 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. Therefore, financial strategies of the various corporate investors will evolve from the apparent volatility of a firm's operating earnings. Finally, 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, behavioral implications of the New Finance, I would like to describe briefly the ethical analytical approach that shall be used. Essentially, a teleological, consequence oriented mode of analysis will be used, as opposed to a deontological, principle oriented mode. 5 (For example, profit maximization by corporations could be ethically justified in a teleological mode if it leads to behavior with favorable consequences for society, such a consumer satisfaction. Profit maximization could be justified in a deontological mode if it reflects the exercise of basic rights and liberties, such as private property.) That is, no attempt will be made to suggest what principles should have been used in developing the New Finance. I am interested only in the possible behavioral consequences of the theory, as it exists, under the assumption that decision makers will actually try to apply it pragmatically to their problems. However, an important caveat is in order here: the analysis of the possible consequences will be deliberately critical and will concentrate largely on negative consequences. In other words, the ethical analysis used here avowedly focuses on undesirable behavioral outcomes of an implementation of the New Finance. An extended, more balanced approach which weighs and sums up the "pluses" and "minuses" might lead to somewhat different conclusions, a point which I shall leave up to the reader's judgment. Undesirable outcomes will be evaluated through the use of a modified Kantian analysis. 6 The basic thesis here is that "undesirable" behavioral consequences consist of any violations of Kant's "categorical imperative." In Kant's words:

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There is ... only one categorical imperative. It is: Act only according to that maxim by which you can at the same time will that it should become a universal law. [19] o f course, Kant's imperative is very similar to the Golden Rule, "Do unto to others as you would have them do unto to you," but it allows for a broader focus on ethical behavior because it includes all human acts, however indirectly or directly they may bear on other individuals. 7 Kant's "maxim" is often interpreted to mean the reason for which a person carries out an act, but it is used here in its literal sense of a general rule of conduct. Accordingly, 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. In effect, we must consider the ethical, behavioral consequences that would ensue if everyone took the normative precepts of the New Finance seriously. Or, to put the question slightly differently, before making a financial decision, a decision maker operating within a Kantian framework must ask himself or herself: "If everybody did the same thing, what would be the moral condition of the financial world?" 8 Thus, although our ultimate concern is with the morality of the New Finance, nonetheless the Kant categorical imperative allows us to frame the question as a practical consideration that concerns the results of an action. Now, let us proceed to raise this question for each of the individual parts of the New Finance.

The Irrelevance Theorem Reduced to its simplest terms, the Irrelevance Theorem, the notion that most corporate financial decisions do not matter, flows from two basic ideas. The first idea is a general argument that the total value of a firm is determined only by its "real" activities, i.e., by the production and sales of goods and services and its investments in assets to carry out those activities. Financing decisions allocate the total

value, between the various equities in the firm, but they do not add to that total value. This idea is particularly prominent in regard to capital structure decisions where choices are being made between debt and owners' equity. Whatever choice the firm makes will be immediately reflected in security market adjustments, of the various equities' risk and return positions, that preserve the total value of the firm. Therefore, financial decisions might be quite relevant for individual equities but are irrelevant for the firm as a whole. The second idea is an axiom that individual investors can imitate, and possibly improve upon, most corporate financial strategies in their own personal finances, so it is not even clear that corporate managers should concern themselves with achieving optimal financial decisions for their individual equities. As Van Home [26, p. 302] puts it, "in order for a corporate decision to be a thing of value, the company must be able to do something for stockholders that they cannot do for themselves." If homemade strategies are possible, the relevance of corporate financial policies would depend only on certain "imperfections" in the real world, a point to which I shall return to below. A related notion here is that, even if the corporation could somehow increase the total value of the firm through clever financial manipulations, the various equityholders would quickly wipe out such increments in value through arbitrage in the capital markets. In effect, corporate decisions on such matters as capital structure or dividend policy are instantaneously offset by arbitrage decisions by individual investors, so corporate managers should concentrate on real decisions involving the production of goods and services. However, the Irrelevance Theorem rests on the existence of perfect capital markets; or, to put it differently, capital market imperfections might create the possibility of increasing the value of a firm through financial decisions. 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. 9 Bankruptcy costs and agency costs,

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which will be discussed below, are also cited as significant imperfections that might encourage firms to use smaller amounts of debt. Finally, it is acknowledged that investors may not be able to follow homemade strategies perfectly. Their risks of leverage, borrowing costs, and institutional restrictions might be quite dig ferent than those of the corporation. These possibilities would seem crucial, if our concern is for the well-being of investors, but they are usually dismissed as being unimportant. Thus, 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, neither of which have known functional re!ationships , so capital structure ends up as an indeterminant variable. Similarly, it also leaves us with a notion that dividend policy is just an irrelevant, passive decision variable) The ethical implications of the Irrelevance Theorem seem clear enough. A peculiar sort of managerial nihilism ensues if it is taken seriously. If all corporate managers presume that capital structure and dividend decisions are irrelevant, the entire burden of determining optimal strategies is thrust upon the investors. In regard to capital structure, managers can be expected to pursue their own self-interests. For example, if job security were of paramount importance to most managers, we would expect a preponderance of suboptimal levels of debt in most corporate capital structures. The actual outcomes here would depend on the risk and return preferences of managers, but the important point is that the preferences of investors would receive scant consideration in light of the Irrelevance Theorem. In regard to dividend policy, managerial sell interest would tend towards no dividends, or suboptimal dividends, being paid. The investors would be left to fend for themselves, presumably by selling shares of stock whenever personal cash needs arose. Again, preferences of investors would receive little attention because it would be presumed that they would pursue homemade strategies. Thus, the overarching ethical implication of the Irrelevance Theorem is that the basic obliga-

tions of the firm to its investors would receive inadequate attention. 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, it would be irresponsible to conclude that those assumptions necessarily reflect reality. 11 Also, it seems plausible that investors would by and large determine the optimal strategies that they should pursue by studying the optimizing behavior of corporations. After all, arbitrage requires that an optimum position exists somewhere. In any case, 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, the managers of firms are obliged to "worry" about the nature of their capital structures and dividend policies.

The Efficient Market Hypothesis

Basically, the Efficient Market Hypothesis states that security prices always fully reflect all publicly available information concerning securities. In efficient markets, security prices adjust rapidly and unbiasedly through the reactions of investors to any newly released information. As a result, price changes in efficient markets behave as random walks over time, which is to say that there is no discernible systematic pattern which an individual could use to advantage as an investor. [10] Extensive empirical tests of the Efficient Market Hypothesis have been conducted, and most of them have not overturned the hypothesis. "Weak form" tests have established that current prices fully reflect historical price information. In other words, superior returns cannot be earned by merely looking for patterns in stock prices. The "semistrong form" tests have determined that security prices also reflect all other publicly available information, especially accounting data. Consequently, superior returns also cannot be earned by only reading annual reports or other published financial news. However, some "strong form" tests have revealed that certain private, non-public

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information is not always reflected immediately in security prices because corporate officers and stock exchange specialists appear to earn superior returns on their investments. Aside from those latter exceptions, 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. The implications of the Efficient Market Hypothesis in regard to managerial behavior seem relatively harmless. 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. That is, given the preponderance of "weak form" evidence to date, there would be no point in waiting for the market to "rebound" or to worrying about whether the market will go higher, when scheduling the issuance of a security. 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. Also, managers would be discouraged from using deceptive accounting techniques because the "semistrong form" evidence suggests that the market will see through such attempts. In a similar vein, 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. The superior returns earned by corporate officers suggest that they do in fact have valuable information to disclose. [3, pp. 409-11] There is, of course, an ethical question imbedded in the superior returns earned by managers through inside information, but that question is not created by the Efficient Market Hypothesis paradigm itself. By and large, the managerial behavior induced by the Efficient Market Hypothesis would seem to be, at worst, neutral, and quite possibly, it might be positive. However, the ethical implications of the Efficient Market Hypothesis are quite different when we turn to investors. In this case, a peculiar sort of nihilism might again result. If

all investors believe the hypothesis and accept its implications, and if they heed the advice of Efficient Market adherents that security analysis is "valueless" [21, p. 100] or that it "doesn't seem to work" [4], no one will be willing to do the analyses necessary ot make financial markets function efficiently. Passive portfolio strategies would replace the attention given to individual companies in traditional security analysis. Complete abandonment of security analysis is probably an extreme prediction. However, the efficiency of security markets would certainly be weakened if a significant number of irivestors decided that it is not a valuable activity. After all, security prices do not emerge from some neo-Platonic shadowy world, but instead, they flow from the collective actions of analysts conscientiously and diligently reviewing all information as it flows into security markets. In effect, a widespread acceptance of the normative implications of the Efficient Market Hypothesis by investors could lead to a major deterioration of security markets. Prices would become more volatile and the volume of trading would escalate up sharply as investors substituted trading for analysis. Solutions, if there be any, to this curious paradox and dilemma will not be offered at this point, but one possible resolution itself raises ethical implications. It is often suggested that investors will continue to try to "beat the market," and thus will perform security analysis, if there is some probability, albeit small, of enormously high returns on some few investments. This view treats investors as being essentially gamblers in a lottery. Perhaps it is not too surprising that proponents of this viewpoint refer to the stock market as a "game." Given the Efficient Market evidence that consistent superior returns on security investments are not possible, this "game" seems to be not worth playing, but well worth winning. Clearly, this normative perspective of the Efficient Market Hypothesis is ethically reprehensible. Investors would increasingly become interested in "long shot" gambles and would welcome security markets characterized by greater price volatility. Ironically, that greater price volatility could be achieved by a general

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abandonment of security analysis by investors. Thus, the Efficient Market Hypothesis paradigm threatens both the efficiency and the societal respectability of security markets if all investors take it seriously.

Capital Asset Pricing Model


Simply stated, the Capital Asset Pricing Model declares that investors pursue optimal combinations of risk and return when selecting investments. The central argument in the model is that risk should be separated into two parts. One part, "unique risk," which is also called "unsystematic risk," represents the risk caused by specific factors peculiar to an individual firm. The other part, "market risk," which is also called "systematic risk," embodies the risk caused by general factors in the entire economy that affect all firms. 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 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. Since unique risk can be eliminated so easily, investors will be unwilling to pay anyone, including the companies issuing the securities, a premium for taking on that risk. Market risk, by definition, cannot be diversified away because firms cannot remove themselves from the economy. Therefore, in security markets, the only risk that matters is market risk, the volatility of the firm relative to the economy as a whole. When combined wkh the previously mentioned notion that investors can pursue homemade financial strategies, the Capital Asset Pricing Model takes on a subtle twist. An ultimate strategy for eliminating unique risk is to simply hold a "market portfolio," i.e., a portfolio consisting of all issued securities. This idea is not bizarre as it may seem at first glance because financial institutions, such as mutual funds, are quite willing to sell shares in large portfolios that are good approximations of market portfolios. However, not all investors

will necessarily desire a portfolio with a market risk level that exactly equals the average market risk. 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 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. Whatever version of the Capital Asset Pricing Model is beheld, its implications for managers are quite clear, and a bit peculiar: managers should not be concerned with managing unique risks because their efforts will not be rewarded by the stock market. Among other things, this advice would encourage managers to ignore such specific risks as bankruptcy, labor relations, new competitors, internal cost structures, technological breakthroughs, local climate conditions, and all the other factors peculiar to a firm. The very "raison d'etre" of managers would seem to be at issue here. On the other hand, the Capital Asset Pricing Model presumably would encourage managers to be concerned with managing market risk. This advice is prone to a "reductio ad absurdum" argument because no one manager can control the movements of the economy as a whole. An individual firm might possibly structure itself in such a way that it would be more or less volatile relative to market movements, but a priori, one market risk level seems as good as another, so even this possibility appears to be a random choice. Thus, the Capital Asset Pricing Model seems to be implying that managers should not waste their time managing any risk at all. 12 The ethical implications of the Capital Asset Pricing Model seem very serious indeed. Given that bankruptcy is a unique risk, 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. Granted, that obligation

The Ethics of the New Finance


must be balanced with the need to earn an adequate return on the firm's investments, 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. Even if bankruptcy can be set aside from the model, 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. Investors may be able to diversify away unique risks, but the employees of a firm cannot follow that strategy. Their major, and for many workers, their only, source of earnings is their wages from the firm and their major investment is the capitalized value of their work skills. 13 Therefore, their very livelihoods are threatened by the Unique risks taken on by their firm, and any managers choosing to be unconcerned about those threats are simply acting unethically. Ironically, managers would also be behaving unethically from a societal standpoint, even within the framework of the Capital Asset Pricing Model itself, if they chose to ignore unique risks. The composition and structure of the so-called "market portfolio" depends on the risk and return choices made by each and every individual firm. The factors that determine the level of unique risk, such as labor relations, for example, are also factors that determine the level of returns achieved by the firms. If all managers choose to ignore these factors, the set of return and risk combinations available to investors will be less attractive than otherwise, a result which penalizes everyo n e . 14

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willing to be responsible for the necessary analyses of the expected risks and returns of individual firms. 16 It is not even clear that such a grand, deductive system could work since "the market" is a conceptual fiction that has no real existence, but in any case, the Model would encourage all investors to let "someone else" worry about the unique risks of all firms. Even in the less refined version of the Capital Asset Pricing Model, where each investor diversifies into just enough firms to wash out unique risk, an ethical issue of neglect still remains. The investors are interested in individual firms only insofar as they affect the total market risk of a portfolio. By refusing to be concerned about the unique risks undertaken by management, investors are throwing most of the burden of unique risk assessment, if not all, onto the employees of the firm. 17 The employees might be able to protect their interests by pressuring the managers to make low unique risk investments, but that strategy also leads to lower returns. Some monitoring of firms' unique risks must be performed, if for no other reason than the market portfolio will become highly volatile if unique risks are not controlled by anyone. But, employees seem the least fit to perform that task. External investors would have the necessary analytical skills and objectivity to perform unique risk monitoring, but the Capital Asset Pricing Model would encourage them to concentrate exclusively on market risk. 18 Thus, the Capital Asset Pricing Model contains the seeds of its own destruction if taken seriously.

Options Pricing Model


Basically, the Options Pricing Model assumes that all equities in a firm represent various options to buy or sell the firm's assets. An option to buy an asset is a "call" and option to sell it is a "put." These options give the holder the right to buy or sell the asset at a specific, "exercise" price. Options do not themselves create anything of value so they are essentially zerosum games, that is, a profit by one party to an option is always an equivalent toss to the other

In the case of investors, the ethical implications of the Capital Asset Pricing Model for them seem similar to those induced by the Efficient Market Hypothesis. Once again, a peculiar sort of nihilism ensues. In the refined version of the Model, investors would have no interests in individual firms at all. A global, anonymous market portfolio and risk-free government securities would be their only investments. 15 In effect, a sort of "One World Financism" would result, in which no one is

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because increased volatility of earnings will increase the value of their call options, all of which works to the disadvantage of the bondholders because options are essentially a zerosum game. Indeed, the Option Pricing Model paradigm becomes more extreme as the firm's riskiness increases. In times of financial distress, 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. They are tempted to play games at the expense of their creditors. [6, p. 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. They suggest that only "out-and-out crooks" would play those games in normal circumstances, 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." 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. [26, p. 268] Also, extensive monitoring of the firm's behavior, perhaps through elaborate financial accounting systems, is expected. These protections are probably imperfect, however. Financial decisions, such as dividend policy and capital structure, can be restrained and monitored at a moderate cost, but real decisions involving production and investments would be quite difficult to monitor and too much restraint would probably inhibit managers from pursuing flexible, creative strategies. In general, bondholders would seem to be extremely vulnerable to managers and owners aggresively pursuing the Option Pricing Model view of reality. The ethical implications of the Option Pricing Model seem quite serious for both the manager and the investor. The view that stockholders

party. Options can contribute to the efficiency of markets, however, by serving as hedging and arbitraging devices. Valuation models of stock options have shown that the value of an option is a direct function of short-term interest rates, time left to the expiration of the option contract, and the volatility of the rate of return on the stock. In that regard, it is important to note that the expected rate of return on the stock is not a determinant of option values. The short-term interest rate generally has the least impact of the three factors determining an option's value. Since the time left to the expiration of the contract is a given, known factor, the crucial unknown factor is the volatility of the rate of return on the stock, that is, the standard deviation of percentage stock price changes over time. Thus, as was the case in the Capital Asset Pricing Model, volatility of stock returns emerges as a major determinant of financial behavior. As a vehicle for analyzing option markets, the Option Pricing Model is relatively innocuous. But, as a paradigm for analyzing the relationships between the various equity holders within a firm, it may well lead to somewhat dubious behavior. Within that viewpoint, all common stocks of firms that have debt in their capital structure can be considered call options. The lenders have acquired the assets of the company, and the stockholders have purchased a call option from the bondholders, which they exercise when they pay off the debt. At the same time, the limited liability granted to stockholders can be considered put options held by the stockholders to avoid the effects of default on debt. As Brealey and Myers put it, "the value of limited liability - the option to default - is the value of a put on the firm's assets with an exercise price equal to the promised payment to bondholders." [6, p. 431] In other, more specific contexts, they baldly assert that stockholders always have the option to "walk away" and leave the firm's troubles in the hands of its creditors. [6, pp. 211-12] Overall, the Options Pricing Model suggests that the optionholders, the stockholders, ought to increase the riskiness of a firm's operations

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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. It is a thoroughly immoral view of finance, which Kant himself anticipated in his borrower example cited above. If all managers and owners adopt the options paradigm, widespread distrust of firms by creditors will be the inevitable consequence. Debt capital will become extremely costly and financial transactions will become heavily laden with legal restrictions and accounting requirements, all of which will seriously impair overall societal welfare. In particular, the Option Pricing Model viewpoint, when joined to the Capital Asset Pricing Model, trivializes bankruptcy of the firm. The advice that stockholders can just "walk away" from financial distress actively encourages firms to court bankruptcy risks. Again, the interests of the workforce and the community in the livelihood of the firm are cynically assumed away as concerns of little importance. 19 The firm just represents a "crap shoot" on a "lottery ticket" subsidized by creditors and employees. It is difficult to defend or accept such a viewpoint, no matter how rich its insights might be. The ethical implications for the stockholder investors are much the same. Any strategy by stockholders that is built upon the premise that they will benefit from the direct losses of the bondholders is highly unethical. The only gains to stockholders that can be ethically justified are those arising out of the creation of real value, through the production of goods and services. 2 While I do not intend to be critical of the use of option markets to make securities markets more efficient, the use of an options paradigm in the internal decisions of a firm would be an odious practice.

seep into financial management textbooks. Also, it has developed along a number of paths, and its ultimate resolution into financial theory is not all that obvious at this point. However, Agency Theory, albeit its somewhat unfinished state, warrants some attention here because it has the promise of being a vehicle for directly dealing with ethical questions in financial management. The general, 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. [17] In this viewpoint, the firm is seen as a set of contracts between the various parties in the production process, including the owners, managers, workforce, and creditors, among others. 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. But, nonetheless, within the firm, the various parties contend with each other for their rights. Thus, in Agency Theory, the center of attention switches from the firm, as such, to the set of contracts that define each firm. In effect, 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. Jensen and Meckling, in their seminal article, 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," or "does the firm have a social responsibility" is seriously misleading. The firm is n o t an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals ... are brought into equilibrium within a framework of contractual relations. In this sense the "behavior" of the firm is like the behavior of a market; i.e., the outcome of a complex equilibrium process. We seldom fall into the trap of characterizing the wheat or stock market as an individual, but we often make this error by thinl~ing about organizations as if they were persons with motivations and intentions. [17, p. 311]

Agency Theory Our last component of the New Finance, Agency Theory, is not susceptible to a simple, brief description. It is relatively new compared to the other components, and it is just beginning to

This view that the firm is mainly a set of con-

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schemes tied to financial "signals," such as the dividend policy or capital structure adopted, and extensive monitoring systems developed by owners or financial intermediaries. [26, pp. 270-72] As mentioned above in the discussion of the Option Pricing Model, complete protection through covenants and monitoring systems would be extremely costly. Virtually every decision would have to be covered and monitored, which would clearly be impossible. 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, but it would tempt the managers to give false signals. Also, financial decisions do seem a somewhat cumbersome way to pass on signals about the firm. 22 Thus, agency theory raises more questions than it answers at this point, and it really has not yet shown up as a source of normative advice in financial management textbooks. However, it will bear watching in the future. 23 If ethical dimensions are woven into it, it could make a very positive contribution to finance theory. However, if it continues on its present somewhat legalistic path, it raises the ethical danger of creating a very contentious, litigious view o f financial relationships, pitting agents against principals and principals against principals as perpetual adversaries. 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: ...the association of human beings, bound together in order to achieve a purpose, is the fundamental and teleological basis for the coming into existence and the continuing existence of a corporation ... without the crystallization of interest about a single purpose conscious in the minds of a group of human beings, 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. It is, then, 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 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. However, Agency Theory has developed along legalistic lines so far, emphasizing the litigious conflicts that will arise among the parties to a firm. Agency t h e o r y has concentrated on the conflicts that might arise between the owners of firms, the "principals," and the managers, the "agents." Also, potential conflicts between the principals themselves, the stockholders and bondholders, have been considered, an issue touched upon here in the Option Pricing Model discussion above. Resolutions of these conflicts can be costly and can significantly reduce the total value of firms and the values of specific equities. 21 Agency costs arise because the managers' incentives diverge from those of the owners. This divergence takes two forms. The managers have an incentive to consume perquisites out of the firm's resources for their own personal benefits; and they have a tendency to pursue easier, suboptimal risk and return strategies for the firm. The first agency problem has received the most attention, but the second one would seem to be potentially much more serious. The managers may simply avoid the trouble and effort required to search out new profitable investments, and they may adopt low risk levels to avoid the anxiety created by higher risk strategies. 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. The predicted resolution of agency costs has developed along two lines. 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. [ 11] The second approach, which is of interest here, presumes that markets cannot entirely eliminate agency problems and envisages the development of elaborate restrictive covenants in debt contracts, management compensation

The Ethics of the New Finance


purpose which creates the focal center, about which the corporation is formed; and without this community of purpose, shared by the group of individual human beings who wish to cooperate in order to attain this common purpose, the corporation would be a legal form without substance. [8, pp. 4-7]

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Recommendations and conclusions In general, 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. If all of the inhabitants of this world take the normative recommendations of the New Finance seriously, the overall ethical result is a pervasive nihilism. The managers are unconcerned about the needs of the investors. They are also unconcerned about the risks facing the firm, even to the point of trivializing the possibility of bankruptcy. The investors are not interested in individual firms, and they are not encouraged to engage in any analysis, other than selecting a homemade risk level for a portfolio. They are encouraged, however, to promote the volatility of returns at the expense of creditors. Clearly, the world of the New Finance is not a nice place ethically. But, what can be done, if anything? Since we are dealing with the ethical implications of paradigms, we can hardly ban them in some sort of intellectual Luddite fashion. The New Finance is a reservoir of powerful ideas in a positive, equilibrium theoretical setting, so it is here to stay, regardless. First, we should recognize that much of the superstructure of the New Finance is built up in equilibrium models. Disequilibria probably abound in the real world, and it is time to turn our attention to those matters. Relaxing the various assumptions of the New Finance will allow for an analysis of those disequilibria. For example, 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. These types of possibilities deserve more attention, and they most certainly should not be assumed away. Second, we should explore the process by which the grand equilibrium of the New Finance is achieved. It is in danger of collapsing in on itself if everyone chooses not to perform the necessary analyses to keep financial markets efficient. New types of monetary reward systems may have to be devised to encourage the necessary analysis, or perhaps a corps of professional analysts will have to be created, somewhat akin to accountants, who would take great intellectual pride in keeping financial markets efficient even though their monetary rewards were somewhat modest. 24 Third, we ought to consider demoting market returns to a lower status as an objective, or to at least make it equal to certain other objectives. The Capital Asset Pricing Model, for example, suggests that unique risks do not matter because they do not show up in market returns, but they certainly show up somewhere. Survival of the firm comes to mind immediately as a financial objective that perhaps deserves equal ranking. Ecological harmony of the firm with its physical environment is another type of objective warranting the same ranking. These kinds of considerations are obviously general and openended, and they cannot be developed further here. However, there is certainly more to life than market returns, and it is probably time to expand our focus in finance accordingly. Fourth, we should return to a greater emphasis on the financial aspects of "real" problems. That is, we should give more attention to the financing needs growing out of investment and production decisions. 25 Firms exist to produce products and services. Finance can help them achieve that purpose by developing powerful tools for capital budgeting decisions, cash flow forecasting, productivity analyses, bankruptcy predictions, and so forth. In effect, it is time to return our emphasis to the workings of the firm rather than the workings of financial markets. Fifth, and finally, we ought to consider emphasizing different human qualities in finance. A cool, detached portfolio investor with no

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ideas to the subject of business ethics, see [1] and [27]. 7 Other ethical maxims are possible, of course, Laczniak [20] lists five maxims that managers might find useful for operational decisions, as follows: t h e utilitarian principle; the professional ethic; the golden rule; Kant's categorical imperative; and the "TV test." s Interestingly enough, Kant himself used a finance example to illustrate his categorical imperative. 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. See [19, p. 40]. 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. 10 Van Horne [26, p. 313] concludes "In final analysis, we are not able to state whether or not dividend payout of the firm should be more than a passive decision variable." 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." This possibility would worsen the problem here. 12 Brose, President of Technology Consulting Group, Inc., observes [7] that a CAPM, portfolio analysis approach can also affect managerial behavior in another way. He states that "it reduces the art of management to a rather simple set of choices. If the current performance of a company meets your corporate objectives, you keep it. If not, you sell it." He goes on to argue that such a viewpoint overlooks the real end of a business, the production of a product of service. 13 Perfectly mobile labor forces could deal with the risk of bankruptcy by moving on rapidly to new jobs, but perfect labor mobility is clearly a rare phenomenon. 14 In other words, the risk-return level of the market portfolio will lie on a less desirable "efficient frontier" if everyone ignores.unique risk factors. 1s The ultimate effect of encouraging investors to hold only a market portfolio is to encourage them to own no securities whatsoever. A bizzare manifestation of this approach is the recent development of stock futures markets, which Business Week [24] describes as "a hot new world" where "investors are able to play the market without owning a share." 16 Ozar [23, p. 299] makes a similar argument in the context of a corporation. 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.

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. 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 , stewardship, and yes, ethical c o n c e r n . 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 , [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 , 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, Fred Kaen, Allen Kaufman, and Dwayne Wrightsman, all of the University of New Hampshire, for their helpful comments, and Jan Landwehr for suggesting the paper in the first place. 1 Findlay and Williams [14], in their excellent critique of the New Finance, deal with the problems that a positive, equilibrium based theory poses for a subject that requires normative arguments. I am indebted to them for many useful insights. 2 Bettis [3] suggests that at least one discipline, strategic management, is generally unaware of the operating implications of the New Finance, much less the ethical implications. He claims that a broad gap in both paradigms and methodologies exists, and as a result, researchers on both sides often do not realize they are analyzing the same phenomena. His observation may well explain why the normative implications of the New Finance have received so little attention. a I am admittedly, and intentionally, passing up the opportunity to evaluate the New Finance in the light of the vast literature on the "social responsibility of business." My own position is that the social responsibility of any organization, including businesses, is to make the world a decent place to live in, and if possible, a better place to live in. 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. 4 The first part is titled the "Irrelevance Theorem," for lack of an official name, but the other parts are titled by their usual names in the literature. I am indebted to my colleague Dwayne Wrightsman for the title "Irrelevance Theorem." Jensen and Smith [18] recently dubbed the theorem as the "Irrelevance Proposition." s I am using Donaldson's [9] meanings for "deontological" and "teleological" here. 6 For interesting discussions of the relevance of Kant's

The Ethics o f the New Finance


17 tn some cases, such as regulated public utilities with "bad" investments in nuclear power plants, they also shift this risk to the firm's customers. i8 Ironically, 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. However, up to now, they have turned over the management of those funds to trustees and institutional investors, and they have not seemed inclined to take on an ownership role. 19 Interestingly enough, those two groups have recently experienced situations in which corporations have used bankruptcy as a way to escape debts owed directly to them, such as union contracts, in the cases of Continental Airlines and Wilson Foods Corp., or consumer damage suits, as in the case of Manville Corporation. See [25]. 20 See Fruhan [15, pp. 284-85] for a very thoughtful discussion of this problem. To my knowledge, he is the only author who has raised this ethical issue. 21 Using agency theory as their basic analysis, Williams and Findlay [31] go so far as to propose that common stock be eliminated from corporate finance. 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." 22 Goodpaster [16, p. 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." He goes on to say that this process will reflect itself in such controls as selectivity of information gathering, choice of managers, and degree of centralization of authority. 23 A pair of articles [12, 13] by Fama andJensen deal with the ways firms are legally organized in light of Agency Theory. These articles contain many useful normative insights, and they probably represent the future directions Agency Theory will take. 24 See Bernstein [2] for a thoughtful discussion of the need for analysts to keep markets efficient. 2s See Vickers [28] for a very rigorous presentation of this viewpoint. As he states it (p. 385), "it can reasonably be asked, therefore, whether the assumption content of such an analysis does not in fact eliminate the real problems to be solved in real world firms, in particular the determination of the actual factor mix, real capital intensity, and thereby the implied risk class of expected income streams. References

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[1] Beauchamp, Tom L. and Bowie, Norman E.: Ethical Theory and Business (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1979), pp. 14-23. [2] Bernstein, Leopold A.: Financial Statement

Analysis: Theory, Application and Interpretation


(Rev. ed.: Homewood, Ill.: Richard D. Irwin, Inc., 1978), pp. 54-57. Bettis, Richard A.: 'Modern Financial Theory, Corporate Strategy and Public Policy: Three Conundrums', The Academy of Management Review 8 (3), 1983, pp. 406-415. Black, Fischer: 'Implications of the Random Walk Hypothesis for Portfolio Management', Financial Analysts Journal 27 (2), 1971, pp. 16-22. Boulding, Kenneth E.: 'The Present Position of the Theory of the Firm', Kenneth E. Boulding and W. Allen Spivey, Linear Programming and the Theory of the Firm (New York: MacMillan and Co., 1960), p. 17. Brealey, Richard and Myers, Stewart: Principles of Corporate Finance (New York: McGraw-Hill, Inc., 1981). Brose, Michael E.: 'The Rise of the MBA and the Decline of U.S. Industry', Marketing News 17 (16), 1983, p. 13. Dewing, Arthur Stone: The Financial Policy of Corporations (5th ed.; The Ronald Press Company, 1953). Donaldson, Thomas: Corporations and Morality (Englewood Cliffs, N.J.: Prentice-Hall, Inc. 1982), pp. 71-76. Fama, Eugene F.: 'Random Walks in Stock Market Prices', Financial Analysts Journal 21 (5), 1965, pp. 55-58. Fama, Eugene F.: 'Agency Problems and the Theory of the Firm', Journal of Political Economy 88 (2), 1980, pp. 288-307. Fama, Eugene F. and Jensen, Michael C.: 'Separation of Ownership and Control', Journal of Law and Economics 26 (1983), pp. 301-325. Fama, Eugene F. and Jensen, Michael C.: 'Agency Problems and Residual Claims', Journal of Law and Economics 26 (1983), pp. 327-349. Findlay, M.C. and Williams, E.E.: 'A Positivist Evaluation of the New Finance', FinancialManagement 9 (2), 1980, pp. 7-17. Fruhan, William E., Jr.: Financial Strategy:

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[16] Goodpaster, Kenneth E.: 'Morality and Organizations', Donaldson, Thomas and Werhane, Patricia H. (eds.), Ethical Issues in Business: A Philosophical Approach (Englewood Cliffs, N.J.: PrenticeHall, Inc., 1979), pp. 114-122. [17] Jensen, Michael C. and Meckling, William H.: 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics 3 (1976), pp. 305-360. [18] Jensen, Michael C. and Smith, Clifford W., Jr.: 'The Theory of Corporate Finance: A Historical Overview', The Modern Theory of Corporate Finance (New York: McGraw-Hill Book Company, 1984), pp. 2-20. [ 19] Kant, Immanuel: Foundations of the Metaphysics of Morals (Indianapolis: The Bobbs-Merrill Company, Inc., 1959), pp. 39-59. [20] Laczniak, Gene: 'Business Ethics: A Manager's Primer', Business 33 (1), 1983, pp. 23-29. [21] Lorie, James H. and Hamilton, Mary T.: The Stock Market: Theories and Evidence (Homewood, II1.: Richard D. Irwin, Inc., 1973), pp. 98--110. [22] Miller, Merton H.: 'Debt and Taxes', Journal of Finance 32 (1977), pp. 266-68. [23] Ozar, David T.: 'The Morality of Corporations', Donaldson, Thomas and Werhane, Patricia H. (eds.), Ethical Issues in Business: A Philosophical Approach (Englewood Cliffs, N.J.: PrenticeHall, Inc., 1979), pp. 294-300.

Whittemore School o f Business and Economics, University o f New Hampshire, Durham, NH 03824, U.S.A.