Foreword
What are you actually getting yourself into, when you buy shares of a company? Or the bonds of a company?
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
History lesson
The first known business corporations were formed in 16th century England. These were mainly linked to the crown and were given monopolistic powers over certain sectors of the economy by the crown. At around the same time, partnerships between private individuals were also being developed, mostly by merchant guilds and other large private organizations(1). With time, these two models took ideas from each other and the culmination resulted eventually in the modern day corporations that we know today.
Originally, corporations were joint ventures, where every shareholder signs up for the venture by entering into a contract with each other. The contract dictates the rules of incorporation, what responsibilities each member has, and also how profits are to be split, forming the basis for the modern capital stack.
Around the early 17th century, the modern joint ventures with limited liability partners signing on via buying shares was invented(2) and that eventually evolved into the stocks and shares that we know today. Each share effectively represents a pre-negotiated fractional share of the company, and within each share class, every share was identical. This treatment allows for shares to be easily sold and traded by removing the friction of having to individually negotiate the ownership with each new investor.
Partners
When you buy shares or bonds of a company, you are, literally, entering into a financial arrangement (bonds are contracts, but shares are not quite contracts, though close) with the company — its management, other shareholders and debtholders. These 3 groups of people (management, shareholders and debtholders) have gotten together to collectively fund and run the company and its businesses, hopefully to the benefits of all parties, according to the articles of incorporation.
In fact, from a legal perspective, as a shareholder, you are literally part of the group that hires the management to run the company on your behalf.
Think about that for a minute.
While buying shares on your brokerage account feels abstract and impersonal, from legal and financial perspectives, it is not really very different from buying a part of a private company, where the contract can be negotiated in a bespoke manner. Now ask yourself these questions:
- Would you go into business with a known fraudster?
- Or someone who has a history of promising grandiosity, but delivering mediocrity?
- Or someone who sells large portions of their shares while encouraging others to hold on to their shares?
- Or people with a known history of fickle relationships with the truth?
- Would you hire someone with the above traits to run your company for you?
And if your answer is no to any of the above, then consider if you should or would buy shares in companies that have majority shareholders or managements (collectively, “insiders”) with similar traits?
Shenanigans
While the law set by Congress and rules set by the SEC/FINRA bound what insiders of companies can do, laws and rules are, by their nature, static while human creativity is dynamic and always changing. So, while the laws and rules prevent insiders from outright defrauding other shareholders, there are still many loopholes and legal grey areas that the less scrupulous insider can exploit, often with the result of enriching themself at the expense of others.
As investors, it is paramount that we look out for such behaviors, identify the perpetrators, and refuse to enter into partnerships with them ever again. Because while in the short term we may benefit from their unethical ways, there is no telling when they may turn on us — after all, a series of spectacular returns is still 0 after an eventual 100% drop.
Footnotes
- Additional reading: https://www.britannica.com/topic/corporation
- Additional reading: https://www.britannica.com/topic/joint-stock-company
Janky Thoughts 