Much business is organized by mutual firms. My purpose here is to present a general economic framework for understanding the objectives of such businesses, and to identify some of the distinctive contributions which mutual organizations make, and the distinctive problems which they face.
THE ECONOMICS OF MUTUALITY
Demutualization of Financial Institutes, ed. D. Heald.
ANNALS OF PUBLIC AND COOPERATIVE ECONOMICS, Vol. 62 No. 3. 1991
Much business is organized by mutual firms. They take savings and they make loans. They insure our lives and our homes. We find them in agriculture and in retailing. Many of our leisure activities, from sports to the arts, are undertaken by not-for-profit organizations. My purpose here is to present a general economic framework for understanding the objectives of such businesses, and to identify some of the distinctive contributions which mutual organizations make, and the distinctive problems which they face.
It is increasingly fashionable to talk about the stakeholders in an organization. Any commercial organization will find itself responsible to five broad categories of stakeholder. There are customers – those who buy or use the products which it sells. There are employees – those who work for it. There are suppliers – those who provide the business with goods and services. Then there are those who provide the capital which enables the activity to be performed – banks, other financial institutions, and shareholders. And finally there are the obligations which any organization owes to the wider community within which it operates.
A powerful and rather general way of looking at a firm is to see it as compromising a set of contracts between itself and these various stakeholders (Williamson, 1975). Some of these contracts are explicit contracts defined in considerable detail. For a loan, the terms and conditions and the security that is offered will generally be precisely and tightly specified. Other contracts are implicit – this is most clearly true of the relationship between firms and the community. Often, as with employments contracts, the contract contains both implicit and explicit terms. All employees have a formal written contract, but there is generally far more to the relationship between the worker and the firm than is written down in such a contract. The firm expects more of its workers than the contract implies, and the workers have reciprocal expectations as to how the firm will behave towards them.
In Table 1 I set out these stakeholders and the nature of the contracts which they make. For each group, there is a flow of physical goods and services matched by a corresponding financial flow. Workers provide their labour to the firm and receive wages in return. The community provides the environment within which the firm operates, and it makes a charge to the firm, in the form of a tax obligation, for that service.
The Firm as a Series of Contracts
With For Reflected In
Employees Labour Wages
Suppliers Materials Input costs
Customers Output Sales revenues
Financial institutions Capital inputs Returns to capital
Community The ability to operate Tax
TOTAL O Added Value
From this contractual vantage point, the job of management can be described in two parts. The first is to ensure that the physical flows in the second column are compatible with each other. The management task is to see that the required output can actually be produced within that environment, and with the labour, capital and other production materials which are available. The second job is to find the best set of contracts which achieve these objectives. In the right-hand column, I list the financial flows, positive and negative, associated with this conception of the firm. These begin from the opportunity cost involved for each one of them – what the goods and services could earn if they were used elsewhere in the economy. In general, these opportunity costs will be reflected in wages, in output prices and in input costs. The balance of these financial flows is the added value or economic rent which the organization creates. It defines the amount which would be lost if the firm were to be broken up and the factors which it employees were to be deployed elsewhere in the economy. The objective of any business activity is to create such added value (Davis and Kay, 1990). In the long run, an organization which fails to do this has no rationale.
Once created, that added value is available for distribution among the stakeholders. In any successful organization, it is likely that all stakeholders will enjoy some share of the value added which it has created. Where the organization is a PLC (public limited company) we immediately think of the profits as accruing principally to the shareholders. (I shall use PLC as a shorthand for a profit maximizing shareholder-owned commercial enterprise.) But there is clear evidence that profitable organizations tend to pay more than the going rate to their employees. Successful firms are generally also those which offer good value to their customers and are ones where suppliers compete for the opportunity to serve. And it is almost axiomatic that the government finds it easier to take more from the successful organization than from the unsuccessful organization. In these ways, all stakeholders typically participate in the achievements of the successful PLC.
Other types of organization distribute the value which they add in different ways. An employee-controlled organization will also seek to create added value, but will then distribute it primarily among workers. In the agricultural sector we often observe supplier cooperatives, which return the added value which they create to that group of stakeholders. A mutual organization stresses the claims of its customers in the distribution of added value. In this way, we can apply the framework of Table 1 to any form of economic organization.
This is not only a helpful way of understanding the relationship between mutual and other forms of commercial organization, but also one which enables us to see some of the special problems of mutuality. The problems with which we are most familiar – and the problems pursued in some of the case studies at this seminar – tend to arise, paradoxically, either when that added value is too large or when it is small. The case of the Abbey National Building Society exemplifies the case where it is large, that of Time Assurance Society where it is not large enough.
It is easiest to create added value – to sell output for more than its opportunity cost – when a firm is operating in an environment which is not competitive. This was often the environment in which mutual organizations came into being. They sought to obtain better value for customers in markets where profit maximizing firms were exercising market power. They derived added value, as did PLCs, but they distributed it to consumers rather than shareholders. As markets become more competitive, the opportunity for firms to make surpluses in this way diminishes. Continued success depends, not on easy monopoly returns, but on trading performance. A wide range of mutual institutions prospered within the British financial services sector, when market conditions were less competitive, but only the most successful have continued to thrive as competition has increased. With the approach of the deadline at the end of 1992 for the implementation of the Single European Act and as other more general moves to deregulation increase the degree of competition in financial markets in continental Europe, so the role of mutual organizations may be expected to change also.
The object of business organization is to add value, but that object is not always achieved. To operate, and to find customers and suppliers who are willing to deal with it, a business has to provide for the possibility that added value will be negative rather than positive. If this is to occur, then some stakeholder or stakeholders must earn less than they could have expected elsewhere. But who? One of the attractions of the PLC form is that it provides a rather clearer answer to this question. Shareholders put up money in expectation of a reasonable rate of return, and if the venture is less successful than they hoped or expected, they will earn less than a reasonable rate of return. Shareholders make a long-term contract with the company in which they are – implicitly – offered an expected yield above the going market rate for safe securities in return for assuming these kinds of risks. An organization without shareholders, whether it is a building society, an agricultural cooperative or a tennis club, has to deal with these potential problems in some other way.
There are three broad mechanisms for doing so and in practice all of them are extensively used. It is essential that those who bear the risk that added value will turn out to be negative are locked in by long-term contracts with the organization concerned. If stakeholders are not locked in to their contracts, they can simply walk away from them as soon as it offers less than similar services earn elsewhere. So although workers do tend to bear some of the risks of commercial success and failure in the organizations in which they work, they cannot bear too much, because in the end workers who are paid less than they could earn in other firms or other sectors of the economy will leave. The same is normally true of suppliers and customers. Shareholders in PLCs make contracts in a form which prevents them from leaving. All they can do is sell those contracts on to other people. But equity risk can be borne by others who are locked into long-term relationships. In the life insurance sector, customers make very long-term contracts. It is not an accident that life insurance is an industry in which mutual organization is both particularly prevalent and particularly successful. Mortgages have some of the same long-term characteristics, and in that sector too we find a widespread use of mutuality.
An alternative approach is to limit the risks which the organization runs to such a degree that the probability that added value will turn out to be negative in practice is very low. This is something which most non-PLC organizations do, either by prudential decision – it is why my tennis club does not engage in property development – or by official regulation. Most mutual organizations have constitutions which restrict their activities considerably more than is normal in the articles of association of a PLC. Sectors in which mutual organization is widespread are often the subject of extensive official regulation, and within the financial sector mutual organizations are frequently more heavily regulated than PLCs.
The third way of protecting against the prospect of negative added value is to accumulate sufficient reserves to enable the risks of unsuccessful trading to be comfortably met. It is difficult, although not unknown, for mutual organizations to begin life in this position. The gentlemen’s clubs of London were founded from the capital subscriptions of their members. But the most successful mutual organizations, particularly those in the savings and insurance markets, have accumulated through past profitable trading a reserve sufficient to ensure that they can now engage in a wide range of activities and yet leave customers, employees and suppliers able to deal with them in the confidence that they will be able to meet their obligations. Singly, or in combination, these three mechanisms of long-term contracting, risk reduction, and the building of reserve assets are the devices which have enabled mutuals to trade successfully and to go on doing so.
When added value is positive – and often substantially so – we confront the issue of whose added value it is. Again, it is an advantage of a PLC form of organization that it gives a very clear answer to this question. It tells us who is entitled to receive these returns and moreover it prescribes the precise proportions in which they will be distributed. For other forms of organization, there is generally much less clarity about this distribution. Even where the constitution does appear to prescribe how added value is to be distributed – as in the split between shareholders and policyholders in most insurance companies and in that between with-profit and non-profit policyholders in a mutual – there still remains the problem of how these returns are divided among different customers. That is a task for the board of the mutual and there are no obvious criteria to govern their choice.
This lack of clarity is both a source of weakness and a source of strength. In the case of some of the strongest mutual organizations, it has enabled substantial reserves to be accumulated which enable these organizations to trade and develop their business with increasing success. But there is then a very large money-box, to which claims are ill-defined, and the temptation to open that money-box and share out the proceeds among current stakeholders is one which may be very strong.
A phenomenon of the 1980s has been the breaking down of what were previously seen as strong historical taboos against the distribution of these accumulated assets. In the case of the Abbey National Building Society, claims against the reserves at the date of flotation were, in effect, equally distributed among the then members of the Society. This has been common in other cases of demutualization. A similar phenomenon can be observed in other non-PLC forms of organization. In partnerships of stockbrokers and estate agents, accumulated goodwill was realized and the proceeds were distributed to the current partners, who may or may not have been those who were responsible for building up these assets and creating that reputation and goodwill. It is almost inevitable that the coming years will see pressures to do the same in other areas where non-PLC organization is common but PLC organization is possible – the partnerships of lawyers and accountants may be cases in point. The breaking open of these money-boxes has been stimulated by the activities of professional locksmiths – merchant banks and other advisers – who see the prospect of substantial fees for themselves in enabling the custodians of the box to realize the value of the contents.
The greater clarity of claims on assets and reserves is an advantage of the PLC type of organization, not only because it resolves what are otherwise ethical problems with no clear resolution, but also for sound commercial reasons. That clarity makes it easier to obtain funds to provide reserves against adverse trading, or to expand the development of the business. If claims on capital assets are clear, capital is easier to raise. But if that clarity is a merit, it may equally be the case that lack of clarity is a merit, because formal clarity in contract form is by no means always a virtue.
Legal theorists (McNeil, 1974, 1978) distinguish three broad types of contract – the classical contract, the relational contract and the spot contract. The spot contract is by far the most common. When we buy a cup of coffee, we make a spot contract – the coffee is made, the money is paid, the coffee is drunk. The transaction is completed by both sides within a few minutes and all rights and obligations are fully discharged. In business we do the same when we buy stationery. But many forms of business relationship involve long-term commitments and durable assets. These are commonly dealt with by means of either classical or relational contracts. A classical contract is a long-term contract in which both parties specify in considerable legal detail the rights and duties of each party. Precisely what will happen in all envisaged contingencies is defined with the contract.
The relational contract is one in which many of these factors are left implicit. The mechanism of enforcement is not recourse to the contract or the courts. It is the need that each party has to go on doing business with each other. Marriage is the archetype of relational contracts, and it is one of the few for which the law makes explicit provision. It allows an exit route if the parties no longer wish to transact with each other but otherwise it leaves the governance of the relationship entirely to the parties themselves. The analogy brings out clearly the advantages of contracting in that particular form. It is a form which relies on trust relationships. It develops free and easy flows of information and a flexibility of response which ensures that the contractual relationship works to the advantage of both parties. It emphasizes the size of the cake rather than its division. These things are possible in a relational contract, but pose difficulties in classical contracting. Here there are generally advantages to be gained in behaving strategically, by withholding information or otherwise inhibiting response (Williamson, 1985). A primary strength of mutuality is that it facilitates the development of such relational contracts. This is true both of the contracts between the organization and its employees, and of those between the organization and customers. It is only necessary to look at the culture of some of the more successful mutual organizations to see the reality of this. This is broadly the “contract failure” theory of the non-profit organization, due initially to Arrow (1963) and defined by Hansmann (1980), but it may also cover “consumer control” – see Hansmann (1988) and Ben-Ner (1986).
Contrast this with what one might call the Boone Pickens view of the corporation, which is that its principal objective is to maximize value for its shareholders. But if a principal objective of the corporation – its fundamental mission – is to maximize value for its shareholders, it is difficult to see why I should stay at work beyond 5.30, transfer to it the skills or information which I hold, be nice to its customers, or remain in its employment a moment longer than the time at which I obtain a better offer from another organization. The more formal contracting of the PLC may be the best way of running a car factory. (Actually, it is not, and results of spot contracting on performance proved generally disastrous (Willman, 1986).) Information flows and flexibility of response are particularly important with the financial sector and it is here that relational contracting is common and important.
But lack of clarity in claims to assets and returns has a price. It diminishes effective accountability. It cannot be said that the modern PLC provides a shining example of accountability to outside stakeholders, but at least there are more and more explicit mechanisms of accountability than many mutual organizations display in practice. This could hardly be more clearly demonstrated than by the paradox of the Abbey members who campaigned against flotation of their building society. They were fighting to preserve a degree of accountability to the membership which the management of the Society patently did not feel. For incumbent management, the contrary views of some of their members were not matters to be weighed in the balance and taken account of in formulation of policy. They were a nuisance to be dealt with by the costly use of public relations advisers and legal processes.
The result of such muted accountability is that there is enormous variability in the performance of mutual organizations. For the best, the structure allows the creation of a wide network of relational contracts and confers the ability to take a long-term view of business development. These are to be found among the most outstanding performers in their sector. One might look here to the performance of cooperative retailers in the early decades of this century. Their relatively weak recent performance demonstrates the variability of wider mutual organization. We might also look to the success of British building societies, which came to dominate the British retail savings market in the face of a complacent cartel of PLC clearing banks. Again, contrast this with the performance of the largely mutual savings and loan sector in the United States.
Let me offer some propositions for debate and discussion. The special value of mutuality rests in its capacity to establish and sustain relational contract structures. These are exemplified in the performance of the most successful mutual organizations, which have built a culture and an ethos among their employees and customers, which even the best of PLC structures find difficult to emulate.
Mutuality is threatened, paradoxically, when it is either too successful or when it is not successful enough. Where it is insufficiently successful, the problem is that of finding stakeholders who will make sufficient long-term contracts with the organization to enable it to survive periods of difficult trading or to develop new activities. At the same time, business is also restricted by the need to minimize operating risk. Most commonly, these problems are reflected in the difficulties which many mutual organizations encounter in raising sufficient capital.
Where mutuality is too successful, the problem of lack of clarity in entitlement to the surpluses which the organization generates becomes more serious. The task of distributing these surpluses becomes more onerous. The temptation to move to a different form of organization, which not only clarifies these entitlements but actually enables them to be immediately realized at considerable benefit to current stakeholders, may become too great to resist.
This lack of clarity about these entitlements is reflected in which is certainly a vaguer and hence often a less effective form of the accountability of managers to stakeholders. With the best management, this may actually work to the advantage of the organization and of all stakeholders in the long term. The disregard of Japanese corporations for short-term returns to shareholders has certainly not worked to disadvantage of investors in Japanese securities. In other cases, the protection of mutuality can breed complacency and inhibit response to change. Perhaps the key question for us to debate is whether a more general framework for mutuality can be found which achieves greater clarity of stakeholder rights and external accountability without jeopardizing the network of relational contracts on which the considerable successes of mutual organizations have so often been founded.
Arrow, K. J. 1963 “Uncertainty and the Welfare Economics of Medical Care”, in American Economic Review, 53, 941-973
Ben-Ner, A 1986 “Non-Profit Organisations: Why do they exist in market economies?” in Rose-Ackermann, S., The Economics of Non-Profit Institutions, Oxford, Oxford University Press, 94-113.
Davis E. and Kay J.A. 1990 “Assessing Corporate Performance”, in Business Strategy Review, 1(2), 1-16
Hansmann, H. 1980 “The Role of Non-Profit Enterprise”, in Yale Law Journal, 89, 835-901
Hansmann, H. 1988 “Economic Theories of Non-Profit Organization”, in Powell, N.W. (ed.) The Non-profit Sector, Yale, Yale University Press, 27-42
McNeil I.R. 1974 “The Many Factors of Contract” in Southern Californian Law Review, 47, 119-174
McNeill I.R. 1978 “Contracts; adjustment of long term economic relations under classical, neoclassical and relational contract law”, in Northwestern University Law Review, 72, 854-905
Williamson, O.E. 1975 Markets and Hierarchies, New York, Macmillan, The Free Press
Williamson O.E. 1985 The Economic Institutions of Capitalism, New York, Macmillan, The Free Press
Willman, P 1986 Technological Change, Collective Bargaining and Industrial Efficiency Clarendon Press, Oxford
Young, D 1983 If not for profit, for what? Lexington, Massachusetts, D.C. Heath.