The SEC recently decided that executive stock options should be disclosed in the table of management compensation only over the life of the deal, not up-front. It knew it was being naughty, so it announced this the Friday before Christmas. Only the unsleeping vigilance of incoming House Financial Services Committee Chairman Barney Frank (D.-MA), ever watchful for malfeasance among Republicans and big corporations, awakened the media to this new attack on shareholder rights.

Management and shareholders are natural opponents. Always have been, always will be. After an entrepreneur has constructed a company, and sold it to outside shareholders, subsequent management consists of hired hands whose main objective can easily become to appropriate as much of the shareholders’ property as possible. The SEC’s new rule assists management in this effort, since it enables it to disguise large stock option grants in the year they are given, reporting them only in later years when they will be regarded as “water under the bridge.”

Before 1929, most large corporations were still controlled by their founders, or by titans of finance such as J. Pierpont Morgan. In the 1930s and 1940s, the prevailing public ethic was so anti-business and the business climate so unpleasant that there were few examples of management malfeasance at the expense of shareholders. Even in the 1950s and 1960s the relationship between management and shareholders remained tolerable.

At that time many companies were still controlled by small groups of very wealthy individuals, while management was modestly rewarded but allowed an existence of country-club coziness. For a top manager in such an environment getting another job was very difficult, and ripping off shareholders involved potentially alienating people who might well prove to be more powerful than him, both socially and politically. With low levels of debt on most companies’ balance sheets and thus a relatively low-stress environment, most managers contented themselves with the psychic satisfaction of doing a good job for the shareholders. This was capitalism as it should be, and in 1947-73 it resulted in the highest productivity growth in U.S. history, far higher than in the vaunted bubble of the late 1990s and since.

Since 1980, this has all changed. In the 1980s, allegedly “dozy” management was attacked by leveraged buy-out companies, who generally replaced management without providing it with particularly generous severance pay or other opportunities. Management resented this, and rightly so. Some examples:

• Beatrice Foods. Immensely successful hostile leveraged buyout 1986 by Kohlberg, Kravis and Roberts. Beatrice CEO James L. Dutt was fired, never held another board position and committed suicide in 2002.
• Macy’s. Went private in 1986 in a group headed by CEO Ed Finkelstein. Was forced into Campeau Corporation in another LBO in 1988. Bankrupt 1992. Finkelstein and his partners lost their entire investment and Finkelstein became a self-employed “retail consultant.”
• Federated Department Stores. Acquired by Campeau Corporation in a hostile LBO in 1988, bankrupt in 1990. CEO Howard Goldfeder was fired. His golden parachute? $3.1 million, not a gigantic sum to live on for a lengthy retirement, even then. The Federated deal, together with Campeau’s previous takeover of Allied Stores, is why there is no longer a Jordan Marsh, nor a Garfinckel’s. In the coming years, all department stores are apparently to be called Macy’s, a retailing environment similar to that of the Soviet Union’s infamous GUM.
• RJR Nabisco, bought by Kohlberg, Kravis and Roberts in a hugely expensive hostile LBO in 1989. F. Ross Johnson, RJR Nabisco’s CEO who organized the auction that spectacularly maximized shareholder value, never held another executive management position. By this time however golden parachutes had exploded in value, so Johnson isn’t poor.

As well as the 1980s leveraged buyout boom, and its associated denunciations of corporate management, a number of other factors affected the shareholder/management relationship at around the same time. Institutional shareholdings, which had represented around 15% of share capital in public companies in the 1950s, rose steadily after 1960 as high taxes, especially estate duty, and inflation decimated the capital of the wealthy while assets held in pension funds and mutual funds slowly built up. By 1980, institutional shareholdings in the Standard and Poor’s 500 Index companies exceeded 50% of share capital, a level they have maintained to this day. Thus the typical large shareholder is no longer a powerful member of the local community, perhaps with family connections to the company, but a mid-level institutional money manager, with no long term commitment to the company beyond its share price performance, no particular social or political power, and representing only a large group of faceless workers or small investors. Naturally, once shareholders no longer had non-financial power, management bad behavior at their expense was no longer socially or politically dangerous.

Another factor in management’s changing attitude was the Steiger Amendment of 1978, which widened the gap between income tax rates and capital gains tax rates, followed by the Reagan tax cut of 1981, which lowered the top rate of income tax. Before 1978, there was little advantage to a top manager in earning enormous sums either in income or capital; they simply attracted punitive tax rates. The Steiger Amendment and Reagan tax cut revived U.S. entrepreneurship and venture capital activity, as they were supposed to; they were equally effective in making existing corporate management greedier and less scrupulous.

This combination of factors caused management to entrench itself. The Delaware merger moratorium law of 1990 allowed mergers to be put on hold for 3 years unless approved by an 85% vote, thus effectively preventing hostile takeovers. In addition the “poison pill” defense was developed in the 1980s, by which “shareholder rights” are triggered by an acquisition of even a large minority of shares by a single holder. Both these provisions should have been struck down by the courts in a system that adequately protected shareholders. They have had the effect of entrenching management against both hostile takeovers and its own shareholders. Needless to say, the orgy of management remuneration followed, exceeded only by the inventiveness of management in devising new ways not to disclose such remuneration to shareholders.

Nothing in economic theory suggests that managerial capitalism of this kind works in the long run, or does anything except entrench a privileged class of corrupt apparatchiks. Adam Smith’s “invisible hand” by which participants in the economy, by exercising self-interest, increase the welfare of all is no longer operational, since management’s greatest self-interest arises from increasing the share of the corporate pie that can be diverted into its own pockets.

It’s true that management can still enrich itself by doing a good job and maximizing shareholder value. However, since this involves competing against other able managers and capable companies, it is far less attractive and easy than several other methods of self-enrichment:

• Management can hire compensation consultants to prove itself underpaid.
• Management can indulge in creative accounting to hide how much it is paid, thereby deflecting possible shareholder outrage (the SEC has now been very helpful to them in this endeavor).
• Management can indulge in more creative accounting to boost earnings by writing off losses against capital as “extraordinary” without bringing them through the income statement. This raises the share price, since reported earnings are higher and can be manipulated into a smooth trend by write-backs of previous write-offs, while the deliberately dozy Wall Street analysts don’t look through reported figures.
• Management can load the company up with debt and buy back shares. In the long run, this endangers the company’s health and makes it vulnerable to recession, in the short run it raises the stock price and makes management richer.
• Management can award itself excessive stock options, and disguise the cost to shareholders of watering their interests by indulging in massive share buybacks.
• Management can further limit the amount of money escaping its clutches by canceling the dividend (to which option-holders aren’t entitled) and doing buy-backs instead. The 2003 dividend tax cut focused shareholders’ attention on dividend income and thereby made this tactic less attractive, since after it there was no remotely plausible reason why shareholders shouldn’t want cash dividends.
• Management can cut costs to boost short term profits, particularly in areas such as research and development where the benefits are long term, and can outsource jobs to emerging markets, even if there are long term structural dangers to doing so (such as the possibility that the outsourcees might learn enough skills to start a lower-cost competitor and put the company out of business).
• Management can enter into discussions with Wall Street to spark a pointless takeover battle and trigger its super-sized “golden parachutes.”

If there are no controls on management embezzling shareholder property beyond management’s self-restraint, then we are no longer in a society in which property rights are respected. Barney Frank made this point in response to the SEC’s decision. Culturally and politically, I would never have expected to agree with Frank, but I do this time. Managerial capitalism is the system practiced in Boris Yeltsin’s Russia, under which the oligarchs made themselves billionaires by fraudulent privatizations of state property. There is no reason to suppose than a move to managerial capitalism in the United States will work any better than that did.

Needless to say, this change in environment has had the usual Darwinian effect in changing the nature of U.S. corporate top managers. Intelligence is no longer a particular asset, since its benefits are primarily long term. Thus only seven of today’s Fortune Top 50 CEOs went to top-tier colleges (Ivy League plus Stanford and MIT) an unimaginably small percentage a generation ago (though some followed an undistinguished undergraduate education with an elite business school, where intelligence appears to be less essential). Conversely, aggression is absolutely vital, particularly when combined with a lack of scruples. Higher stress and higher rewards in the executive suite have naturally resulted in behavior deterioration. Dennis Kozlowski, he of the $6,000 shower curtain, former CEO of Tyco, a graduate of Seton Hall University now serving 8 to 25 years in jail, is the archetypal CEO of the modern era.

Solutions? There aren’t many. Institutional investors need to band together against management in shareholder votes far more than they do currently. Most important, every detail of management’s arrangements with the company needs to be put to a separate shareholder vote, as does the appointment of the auditors (as I have written previously, proposals to carry out audits should be presented to shareholders directly, not to management). The poison pill and merger moratorium laws need to be removed, if necessary by Constitutional amendment specifying that corporations must be run for the primary benefit of shareholders.

This is all a long term proposition. Meanwhile investors should seriously consider alternative markets such as Japan, Germany or India, where their interests are better respected.

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(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 the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. 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.)