The Bear’s Lair: Shares, not stakes!

A Cato Institute seminar on business ethics Friday highlighted for me how much the excesses of the ’90s were due to misguided ethics teachings.
Traditionally, businessmen were taught that their duty was to protect and advance the financial interest of shareholders, no more, no less. Business ethics were not taught in school, because the ethical principles of business were believed to follow closely those of life in general. Successful businessmen were assumed to have had a solid middle class upbringing, with an appropriate indoctrination into one of the Judeo-Christian ethical systems.

Businessmen were not expected to be altruistic; it was recognized that altruism was appropriate, if at all, only in their private lives. Instead, businessmen were supposed to seek the maximum possible profit for themselves, or if they were not the owner of the business, for their shareholders. The activities of company management were governed by agency theory and law, which unambiguously provided for managers to make shareholders’ interests their top priority at all times.

Naturally, a certain amount of legal structure was still required. For one thing, as Adam Smith said “people of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” For another thing, rogue businessmen could and did exist, more so in some trades than in others — commercial banking was supposed to be particularly “white shoe” in its probity, whereas brokerage, trading in general, used car dealing and trucking were notoriously populated by the rougher specimens of mankind, with less developed ethical senses.

The traditional, fairly clear, ethical system under which businessmen operated was altered from the late 1960s onwards by several intersecting trends. First, leftist social engineers decided that it would be nice if their social engineering could be funded by the business community, so they invented a “social obligation” of business, by which it could not concentrate solely on profit. Part of this “social obligation” was environmental, and part was related to equality between races and sexes, but both constraints could have been imposed on business by society, as had been traditional, without businessmen being asked to focus on objectives other than business profit.

Second, the normal run of minor business scandals was treated by the media as a novel and serious problem, which it was alleged could be solved by the institution of “business ethics” classes in business schools. The most celebrated such institution came at Harvard, where John Shad, former chairman of the Securities and Exchange Commission, in the middle 1980s donated a substantial sum to the school in order that the first year business course should include a substantial element of ethical teaching.

Third, the multicultural movement of the period led to a devaluation of the wisdom of “dead white males,” a de-emphasis of their teaching in school, home and church, and an arrival in business management of a generation brought up to Clintonian moral relativism. For the baby boomers, if it was legal, or even if it was illegal but untraceable, there was no problem with it.

The confluence of these three forces produced a new synthesis, an ethic of “stakeholder” capitalism, in which businessmen were supposed to consider not simply the interests of shareholders, but also the interests of employees, business partners, suppliers, and the community as a whole. It was alleged that by considering the demands of all these “stakeholders” in a business, management could optimize business’s social performance as well as its financial performance.

Needless to say, the ethics professors did not think through the likely practical results of removing businessmen’s existing moral compass and providing them with another, which pointed in several directions at once. For if two “stakeholders” clashed, whose interests were to be favored?

As well as ethical difficulties for businessmen, stakeholder capitalism contained a clear internal contradiction. It has been pretty clearly demonstrated by economists that, under assumptions that are at least generally true, pure capitalism, that allocates goods and services by the price mechanism, and in which management acts solely as the agent of the shareholders, is an optimal economic system, in which wealth is maximized, and new wealth created with considerable rapidity.

There is however no equivalent proof of the optimality of stakeholder capitalism. Furthermore, once management ceases to act purely as the agent of the shareholders, the new system contains very little in the way of a priori guidance for management as to what it can and cannot do.

The result, since 1973, has been economically unattractive. Productivity growth from 1973 onwards declined catastrophically, and took two decades to recover, because management was no longer seeking to optimize the system, but simply to enrich itself and to satisfy important political constituencies. The “productivity miracle” since 1995 has been no more than a partial return of productivity growth to pre-1973 levels (it still appears to be at least 1/2 percent per annum below its 1947-73 mean) as the adverse effects of ’70s management changes finally worked their way through the system, and at last ceased causing further systemic distortion beyond that already in place.

Naturally, since management no longer had to act as agent for the shareholders, it developed various theories under which it too was a stakeholder, and was entitled to an exceptional share of the rewards from the business.

The rise of management compensation by stock options, for example, was designed to align management’s interest with the shareholders’, but in fact, with options not being expensed, did no such thing. Instead, shareholders were told that stock options were not a true cost to them, but simply reflected a dilution of their interest in the business. Management, which had most control over the day to day operations of the company, no longer saw shareholders as the entities to which it was responsible, but instead as simple providers of capital. Provided the share price trended generally upward, shareholders could be ignored, and management rewarded for its “entrepreneurial” skill. This was particularly the case in the tech sector, in which managers, generally not the brilliant engineers who developed the new products but largely administrators, saw themselves as giants of entrepreneurial capitalism and rewarded themselves accordingly.

In fact, of course no entrepreneurship was involved; management was not assuming the risks of the business, which remained firmly with the shareholders, but simply gaming the rewards system so that the great bulk of the rewards went to it.

Naturally, in a system of stakeholder capitalism, with the proper rewards for the different stakeholders undefined, management, as a stakeholder, but one with exceptional power over the running of the business, decided that its stake in the business was of greatest importance and should accordingly be most rewarded. Under stakeholder capitalism, there is no longer any reason of principle why it should not act in this way. Kenneth Lay and Andrew Fastow are the inevitable result of this system of ethics.

For a number of years, stakeholder capitalism appeared to work well. Shareholders appeared to be given adequate returns, while management gloried in ever more grandiose stock option schemes, ever more Pharaonic lifestyles. Other stakeholders were more or less ignored, except in so far as satisfying them soothed some political constituency and enabled the game to continue.

It all had to end sometime. The game that was being played was no longer capitalism; indeed, under the old ethical code it was embezzlement of shareholders’ money. Eventually, the disconnect between the money that was being sucked into the tech sector and the anemic or even negative returns that were being earned grew too great.

Once the tech sector cracked confidence, ever so slowly, began to leak away from the rest of the market. It was only a matter of time before one of the more extreme stakeholder capitalist firms ran out of liquidity and exposed the system for the fraud that it was. In the event, because the derivatives business is exceptionally volatile and requires huge access to emergency cash flow, it was Enron that cracked, soon to be followed by a sorry parade of failure that has by no means ended. The ethical bankruptcy of stakeholder capitalism was exposed, and the system, in spite of frantic attempts by the Fed, government and the corporate sector to prop it up, is collapsing slowly into rubble.

The solution is simple but painful: we must return to a system whereby managers are “hired hands” responsible to the shareholders for who they work. Since it is impossible in under a generation to re-educate the entire business class in shareholder capitalism ethics, the incentives in the system must be redesigned so that management is forced to focus on shareholders as, to make a capitalist system work, it must.

To do this, shareholder attention must be re-focused as soon as possible on dividend income, and on its sustainability, and away from the chimera of easily manipulable and transient capital gains. The president’s tax plan is a step in this direction, but a flawed one. Under it, the majority of shareholders in most companies, being institutions and tax-protected individuals, will get no additional advantage from dividend payments, so will exert no pressure on company management to increase them. The further wrinkle in the plan, by which retained earnings would also be tax deductible for capital gains purposes, is an outrageous and unworkable attempt to avoid paying dividends and preserve the late ’90s management gravy train.

Dividends must be made tax deductible at the company level, so that management is forced by the shareholders to pay out excess cash flow, and has no incentive towards tax shelter/haven investment, nor toward excessive leverage.

Stock options must be accounted for as an expense, so that management is forced to account for all its compensation on the same basis. Ideally, options would also be made taxable at the time of grant, leading companies to move towards payment by share grants in lieu of salary, rather than by options.

Auditors must be appointed directly by the shareholders, with all proposals to act as auditor presented directly to shareholders for approval. If management appoints auditors, there is every incentive to cheat.

The fiduciary duty of management to shareholders must be made legally explicit. “Poison pill” takeover defenses must be outlawed, as must excessive “golden parachutes.” Equally, management that engages in empire-building takeovers should become legally liable, at least in extreme cases, if they turn out badly. Takeover bids must become less common, but defense against them must become more difficult.

With the tax change on dividends, preferred stock must once more be used as an active element in corporate financing. Preferred stock carries a fixed dividend, and has no control over the company unless that dividend is not paid. It is thus a mechanism by which, if management wishes to raise capital in a form that does not convey a full-scale fiduciary duty to its owners, it can do so. In cases where management and the company have a good track record, preferred stock will find a ready market, as it did in corporate financing in the early part of the 20th century.

By this series of reforms, each modest in itself, the incentives to management will become realigned with shareholder needs, and the conflicts of interest inherent in “stakeholder capitalism” will be eliminated. Business interactions will no longer be conducted in the spirit — very costly for the economy — of the used car dealer selling to the trial lawyer. Risk in the stock market will be reduced, and the economy will work more effectively, with less tendency towards damaging investment bubbles such as that of 1995-2000.

“Stakeholder capitalism” like a vampire, has sucked the blood from the U.S. economic system. Drive a silver stake through its heart, and let it expire unmourned!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International