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In the tradition of Coase (1937), Demsetz (Alchian and Demsetz, 1972), and Williamson (1975) the firm is understood as a nexus of contracts. The difficulty in fully specifying contracts in all cases means that contracts are often incomplete (Grossman and Hart, 1986; Hart and Moore, 1999). When relationships between stakeholders are complex, null contracts become common (cf. Hart and Moore, 1999), and promises play an important role in maintaining the cohesion of the firm and in confirming its position. In addition to contracts with its stakeholders, then, the firm also makes promises, e.g. about the duration and development of contractual relationships, or about price levels to be expected in the future. Hence, the firm can also be understood as a nexus of promises.
Whereas contracts engage the liability of the firm and its executives, promises engage the credibility of the corporate actors who make them. Contracts try to leave as little room for interpretation as possible and are governed by a strict legal hierarchy of claims on the firm that clearly defines who gets paid first, second, and third. Promises, on the other hand, leave more space for manoeuvre; the hierarchy of promises is not clearly defined ex ante. If promises to different stakeholders make up an important proportion of the engagements of the firm, then it is necessary to develop an understanding of the factors that determine the hierarchy of promises. Indeed, the firm and its executives may make contradictory promises to different stakeholders, for example promising job security to domestic employees and, at the same time, promising heavy investments overseas to clients and shareholders. Which of these promises is more likely to be kept, in the event that the firm is unable to honour all of them?
A particularly good fulcrum for analyzing the logic of the hierarchy of promises in the firm is the publicly listed firm’s promise of an increase in return on equity (ROE), as practiced by numerous financial institutions (banks, insurance companies) in recent years. Promising an increase in ROE has significant implications for both shareholders and employees. Unlike quarterly earnings forecasts that provide immediate feedback on the performance of management and are therefore taken by the financial markets as a proxy for the health of the firm (cf. Graham, Harvey, and Rajgopal, 2005), increases in medium-term ROE targets represent a statement of intent concerning the future direction of the firm. Given that a focus on achieving a higher ROE has implications for both risk and long-term sustainability, employees are being told that their prospects in the firm are likely to be more unstable and of shorter duration. In other words, the promise to shareholders of an increase in ROE may contradict growth and career promises made to employees, quite apart from the employment contract.
Taking the promise of an increase in ROE as a test case for exploring the hierarchy of promises in the firm has the additional feature of allowing us to distinguish between different types of shareholders and different types of employees. An increase in the ROE target does not affect all shareholders and all employees in the same way; whereas for some types of shareholder an increase in the ROE target is not welcome (i.e. long-term shareholders who eschew risk), for some types of employee it is (i.e. those employees who are most likely to benefit financially from the increase in ROE and who are least dependent on the firm for their long-term prospects). Thus, we can use the particular case of an increase in the ROE target as a basis for discussing how a hierarchy of promises gets established both between shareholders and employees and within those two stakeholder groups.
In the first section of the paper, we articulate the meaning of understanding the firm as nexus of promises, showing how the tendency towards null contracts in a world of increasing complexity makes promises central to governing the firm. In the second section, the heart of the paper, we work out the structural determinants of the hierarchy of promises in the case of an increase in the ROE target. We build on this argument to develop propositions about the relationship between the organization and composition of employees, on the one hand, and the organization and composition of shareholders on the other, and the propensity of firms to make promises to increase the ROE target. In the final section, we move beyond a structural explanation to explore how executives of the firm choose to ally with employees or shareholders. This last part of the paper draws on a discussion of the recent history of the financial services industry.