Why Corporations Do What They Do

Alden Wicker

Posted on Oct 14, 2011

Last week, you were understandably outraged when we revealed all the new ways banks are levying fees on customers:

“They continue to post record-breaking profits quarter after quarter,” said reader Lara S. “Hitting their customers when they are down is unethical.”

Reader Sandra W. put it more simply: “GREED, GREED, GREED!”

And we get it. During a down economy with high unemployment, nearly record levels of poverty and people protesting Wall Street greed all over the world, it feels like a slap in the face for banks to charge customers even more just to access their own money. Bank of America must have known that this would infuriate its customers and send ripples through the media.

So really, why would they institute this new fee?

In this week’s issue of The Market, we’ll break down why companies do what they do. From golden parachutes to shareholder activism, corporate motivations come down to a large tangle of issues, but today we’re going to keep our focus on the basic outline: the relationship between corporations and their shareholders.

Who’s the Boss?

One of the biggest differences between a large corporation and, say, a local corner store is that small business owners are accountable only to themselves, while corporations are accountable to thousands of “owners.”

Imagine your local pharmacy is owned and run by your neighbor. You’re short $50 for medicine you need, so she spots you and says you can pay her back later. She can do that because it’s her business and her money to lend. But if you go to Walgreens, the pharmacist can’t spot you $50, because it isn’t his. That $50 belongs to the owners of the Walgreens corporation.

And in this case, those owners are shareholders.

Every time you buy a stock, you’re buying a small portion of a company. If the company does well, the value of your stock will go up … and vice versa. So, if you owned Walgreens stock, you probably wouldn’t appreciate pharmacists handing out free prescriptions, especially to random people you’ve never heard of.

In a nutshell: Even the head of a corporation can’t make a decision singlehandedly, because it’s not all her money, and she’s accountable to her shareholders.

Meet the Board of Directors and CEO

A corporation can’t possibly consult its thousands of “owners” for every single decision, so shareholders choose a Board of Directors, which in turn chooses a CEO. Together, they have a legal responsibility to act on behalf and in the best interests of the shareholders. Many of those shareholders are regular people like us, or mutual funds in which we invest our nest eggs for retirement.

And It Is a Legal Responsibility

If a CEO or Board of Directors put all profits toward saving the rainforest in Brazil, shareholders would have every right to sue the Board, and they most certainly would … no matter how philanthropic and wonderful the act. After all, that’s their money the Board just gave away.

In order to make sure the CEO always puts the interests of shareholders first, the Board of Directors almost always ties the CEO’s compensation to the stock price. Although many people (especially those protesting on Wall Street) feel that CEOs are grossly overpaid, the theory goes that they’ll do a better job of getting the stock price up if their compensation is tied to it. For example, most of the highest paid CEOs in 2010 led their companies to profitable quarters and strong growth of share prices.

So, if CEOs don’t do everything possible to keep share prices high, they’ll personally earn less and run the risk of being ousted.

In the case of B of A, a new bill (the Durbin Amendment to the Dodd-Frank Wall Street Reform Act; read here for details) could hack away as much as 70% of banks’ profits. And it’s not enough for corporations to just make a profit every year. Shareholders expect a corporation’s profits and value to always be growing (that’s why you invest for your retirement, because you expect your money to grow). So, strictly speaking, it’s the CEO’s job to find ways around this slash in profits—even if they’re sneaky!—in order to keep share prices going up and up.

Where This Can Go Wrong

Although this system concerned primarily with raising stock prices helps shareholders earn more money, it can also have serious drawbacks.

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As you can imagine, the interests of customers, employees and the environment don’t always align with the interests of shareholders who just want to see a profit. It’s often (though certainly not always) more profitable to pollute, use low-wage labor in developing countries and gouge customers … with $5 debit card fees, for example.

Essentially, in order to start putting customers and the community first, a CEO would have to convince the board and shareholders that the company can be both altruistic and profitable—a tall order.

What This Means for You

So, that’s the rough outline of how the system works.

But you certainly don’t have to agree with it. The best way to convince a corporation to act responsibly is to punish them if they don’t. In other words, if you feel strongly about something, boycott. If you’ve got beef with the big banks, you’re in luck; a boycott against them is already being organized.

The executives at Bank of America made a calculated risk when they announced the $5 fee on debit cards, figuring that enough people would stick around and pay. But if enough customers defect, profits could suffer, the CEO would ostensibly be paid less, shareholders would holler and, just maybe, Bank of America would repeal the fee.

Of course, if you have Bank of America in your portfolio, well, you’d better hope that customers stick around and pay up.

Image credit: LifeSupercharger on Flickr