The Legal and Market Systems Finance Essay

Introduction

The argument for this article is focus on maximizing firm's value to society through firm's ethical business decisions which require incorporate with the three forms of justice; economic justice, legal justice and distribute justice, in its business decision in order to protect stakeholders' alienable and inalienable rights (indebtedness) and wealth maximization with minimum social waste. Pareto optimal efficient market exists when there is no feasible allocation of resources which can make some individual better off without making someone else worse off, Stiglitz (1981). The three forms of justice not incorporated when Pareto optimal business decisions has not make. Thus, it indirectly reflects that the stakeholders' rights will be violated because of the unfair redistribution of both residual and non-residual claims. To achieve Pareto optimal business decision, three forms of justice should require to be integrated. Besides indebtedness, 'moral debt' is an additional firm's obligation which occurs when the firm takes some sort of benefits from other stakeholders through not fulfilling just business decisions. To increase the firm's value to society, the incorporation of all associated 'moral debt' claims should be include in its business decisions. However, a strong economic argument had incurred that a better protection on stakeholders' rights should be enforced by laws and regulations while engage with society.

2. The role of the legal and market systems: a change in perspectives

The main objective of the firm in the traditional financial economic perspective is to maximize shareholders' wealth. The results from having these perspectives are agency costs, conflicts of interest, and asymmetry of information between shareholders and stakeholders. Agency costs results from the managers not having same interests as shareholders and also the conflict of interest between employees and managers. Asymmetrical consequences are resulted from conflicts of interests. Thus, the shareholders or managers will gain upside benefits from non-Pareto optimal business decisions whilst the stakeholders and society will bear the down side costs. Laws and regulations are required to solve the non-Pareto optimal business decisions in order to help goal congruency by ensuring that the firm and director share in the downside costs. There should be more direct link between business decisions and consequences in order to allow more symmetrical distribution of the upside benefits and downside costs. This will encourage the agents of the organizations to integrate the "moral debt" claims in their business decisions by more symmetrical acknowledgement of the rights of stakeholders. The market system does not require more regulations since the courts should enforce all contracts. Those contracts are the important underpinning of the market system. However, it is assumed that the sophisticated (informed) issuers and sophisticated borrowers have been negotiated. Some researchers reject the argument in the traditional perspective that the competitive market system and legally binding social contracts are sufficient to keep markets efficient in the Pareto optimal sense and sufficient to protect all shareholders and stakeholders' rights. La Porta et al. (2001) find that legal systems throughout the world vary in the way they formulate legal rules and enforce such rules to protect shareholders' rights. Shleifer (2005) found out that countries with market systems associated with contracting theory are not always effective due to market limitations and frequent subversions of the courts. Generally, good protection and enforcement for stakeholders' rights will limit the conflict of interest, agency costs and "moral debt" claims between inside and outside stakeholders. La Porta et al. (2001) suggest that all outside investors' of the firm need their rights protected and that if rights enforcement is absent then insiders would not have much reason to distribute profits.

3. Going beyond the legal and market systems for Pareto optimal business decisions

Donaldson and Dunfee (2002) argue that there is a moral need to go beyond the market and legal systems to enforce contracts due to the fundamental in maximizing society's wealth. Andolfatto (2002) and Feldman (1971) demonstrate that the well functioning market system will potentially work against fair distribution of claims (social policy) that requires the legal system through government intervention to protect inalienable rights. Initially, based on Chandler, 1998; Pieper, 1966; Schumacher, 1993; Steiner, 1999, we have to understand that individuals have the right to goods to satisfy their basic survival needs and that society as a whole is obligated to satisfy 'moral debt'. The firm needs to protect the alienable and inherent inalienable rights and claims of all stakeholders in order to maximize the value of the firm to society. Shleifer (2005), La Porta et al. (1997, 1998, 2001, 2004), Shleifer and Wolfenzon (2002), Glaeser et al. (2001) and Beck et al. (2000) observe that countries that have strong regulations and enforcement for the protection of stakeholders' rights find improvements in development and public participation in their respective capital markets. Ultimately, "moral debt" cannot be totally monitored by legislation alone. It requires the power from the individual, the firm and the government to be "just" in their decisions and actions. Morrison (2004) observes that the series of frauds and the government's response to those frauds have serious and wide-ranging consequences to the stability of our financial system. Thus, it is necessary to ensure distributive justice in order to help in satisfying stakeholders' "moral debt" claims through their alienable and inalienable rights.

4. The 'moral debt' distribution model and value-resetting

There are 6 assumption of the moral distribution model. Firstly, when there is a claim by the 'moral debt' holder towards the liable firm, it will involve money of shareholders with everything remaining the same. Secondly, huge 'moral debt' responsibility firm may have value to shareholders but may not to society because claims are redistributing. Thirdly, maturity date of the debt can be immediately and continuing due to the present of transferable right. Fourthly, whenever a firm exists, the total face value of the debt will not be zero. Fifthly, the debt claim might not be lawfully applicable. Lastly, through ethical behavior, value to society is maximized by firm when it distributes its wealth equally and residual claims are attained. Figure 1: The 'moral debt' distribution payoff graph Based on Figure 1, typically, the value to society by firm is lesser than to shareholders when the 'moral debt' is not evenly spreading out. The decision is within the market and lawfully acceptable but immoral. So, it will not incur any external costs. It is non-Pareto efficient. Thus, consideration must be given before the firm realizes its obligation to the society. The market value of the firm (MV) is equal to equity plus debt. The value of the 'moral debt', DMD is equal to total debt, DT minus financial debt, DF. If the DMD is more than 0, the value to shareholder, VSH is more than to society, VSOC. Thus, firm can decrease the DMD to 0 when DT -DF and so VSH =VSOC. The VSH is maximized when the maximum cost to shareholder is 0 because of the limited liability status of the firm and 'moral debt' that unfulfilled the lawful application. The VSOC is maximized when the maximum cost to society it is at -DT because of the total redistribution of claims. Figure 2: The 'moral debt' distribution payoff graph (decrease the 'moral debt' claims without any changes in share price). Based on Figure 2, it is more effective to decrease the 'moral debt' when the firm evenly spreading out all the claims. The decision is within the market, lawfully acceptable and moral. So, it will not incur any external costs. It is Pareto efficient. To decrease the 'moral debt' claims, the VSOC will increase when the society's payoff move to the left to the society's new payoff, with everything remaining the same, because the firm meets its obligations. It will lead to a more optimal Pareto. The market value of the firm (MV) is equal to equity plus debt. The value of the 'moral debt' before evenly spreading, DMD is equal to total debt, DT minus financial debt, DF. The value of the 'moral debt' after evenly spreading, DMD is equal to total debt, DT2 minus financial debt, DF. The value to shareholders before evenly spreading is VSH and after is VSH2. The value to society before evenly spreading is VSOC and after is VSOC2. Figure 3: The 'moral debt' distribution payoff graph (decrease the 'moral debt' claims and resulted in the decrease in share price). Truthfully, when the firm meets its obligation, it affects the residual claims available to shareholders. It will produce a 'value-resetting' in the share price and so to the firm's market value. Based on figure 3, the decision is within the market, lawfully acceptable and moral. So, it will not incur any external costs. It is Pareto efficient. The share price is affected when there is efficient competitive market at discounted future cash flows. With everything remaining the same, when the 'moral debt' claim decreases from DT DF to DT3 DF , the market value decreased from MV to MV3 because the firm's equity revalue the firm at MV3 using the 'value-setting'. There will be more even spreading of claims which resulted the movement of the society's payoff line to the left so that the value to society of the firm increases from VSOC to VSOC3 while the value of the firm to shareholders decreases from VSH to VSH3. The decrease in the value of the firm to shareholders is not a loss but a 'value-resetting.' In the figure, the firm is over-valued in value-resetting is due to the non-Pareto business decision. This decision benefited the large investors and not the society or stakeholders. Due to the fact that large investors rather maximize their own benefit than distributing maximum residual claims. If there is not any protection over the stakeholders, the social costs will be bear by the stakeholders as the benefit is the shareholders. Therefore, the risk can be covered by law and regulation by implying constraints on management decisions. This is when there are not any transferable or nontransferable rights, as the wealth is redistributed, at any near future time. The extent of the law and regulation will determine the capital market effectiveness. The risk can also be covered with the agency costs when the firm's is nearly bankrupt to a stronger firm with higher risk investment. It forces the redistribution wealth to be transfers from stakeholders to shareholders. However, there will be no welfare loss if there isn't any wealth to redistribute. There are 2 situations where over-valued can incurred. First is when the 'moral debt' obligation is not exercise. Thus, the firm will find a more controllable market value and equity value which lead to higher value to the society. The second event is when the firm has limited liability like the partnership. This is because unlimited liability firms have a better contract compliance and monitoring. Costs incurred for the law and regulation implied was fixed while the costs incurred during the market system cannot be fixed. The usage of this market system is to provide clear prices and express and accumulate information. Value-resetting is one of market system correction. It enables the firm inference the stakeholders 'moral debt' claims to make ethical business decisions.

5.0 Business decisions, externalities and share price over valuation

Externalities described an allocation of transferrable ownerships to other in a designed economy. It constitute of two components, a normal good and public good, the advantage or threat to others. Business decisions that take into consideration of moral requirement are distributive justice and others two justices in defending rights and deduce externalities. Governance interferes only happen when externalities risk cannot be offset in capital market. Externalities occur when private cost of firm cannot fully cover social costs of particular business decision. For the market efficiency, traders shall make rational judgment and utilize their property rights. Stakeholder must realize future benefit and costs to transfer any ownership and special oversight are needed to defending stakeholders' right and to reduce redistribution of stakeholders' claims. Firm value maximization cannot achieve with the presence of externalities in the firm value to society. When externalities increase, firm can obtain advantage from redistribute claims and further make an overvaluation to the firm share price. Shareholder will better off but on the other hand the society is worse off. In conclusion, firm can raise its share price from two approaches, by being Pareto or non-Pareto optimal. Pareto used ethical business decisions to allocate claims and apply value resetting of the firm's equity. This can increase stakeholders' value to maximize firm value to society. Non-Pareto optimal business decision by reallocation of stakeholders claims that increase the conflicts of interest and assist an over valuation of the firm's equity. This may not provide benefit to shareholders but it may benefit selected group like management or majority shareholders, but this will eventually decrease the value of the firm to society.

6.0 Conclusion

To maximize firm value to society, firms shall incorporate stakeholders' moral requirement into business decisions, which do not have legal and financial control on transferable ownership in the firms. When shareholders, directors and governments realize the obligation of "moral debt" and go further beyond existing corporate governance, this will eventually increase the value of the firm to society.

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