The Paradox of Shareholder Value


Our Clandestine Corporate Lair

Today is our annual shareholder meeting, here at our clandestine corporate lair. The board of directors will be meeting in the morning, followed by a presentation to shareholders of our company stock. Typically, the crowd is made up of 30-40 elderly, former employees who live in the area and have nothing better to do in their retirement. It is essentially a rah, rah presentation by my Dark Corporate Overlords, for the handful of loyal retirees that choose to show up.

So, in honor of this annual event, I would like to take a few minutes to explain what it is that I think is wrong with the concept of the shareholder owned corporation. Please forgive the long, dry rant that follows…

In large public corporations such as our Sinister Cabal, the company is “owned” by thousands of different shareholders. As such, it would be impractical for each owner to participate in the decision making of the corporation. Therefore, the shareholders of our stock have an elected board of directors to oversee the management team, and the operation of the company on behalf of all owners (ie. shareholders). The ownership of one share of company stock entitles the shareholder to one vote in the election of the board of directors. Therefore, effective control over the board of directors rests with the majority shareholder, or groups of shareholders acting in concert.

In the case of our fine corporation, employees are given the opportunity to own shares in the company stock through their retirement funds, or through outright purchase of company stock using pretax dollars. In addition to the employee stock holders, wholesale institutional investors, like large mutual funds, will typically buy and sell shares of our company stock as part of their investment portfolios.

In theory, this seems like an excellent example of the principle of economic subsidiarity, whereby the workers share in ownership of the capital. The theory of economic subsidiarity, as described by Pope John Paul II in his encyclical Centisimus Annus, proposes that “Each person is fully entitled to consider himself a part owner of the workbench where he is working with everyone else”. By having the employees participate as shareholders of the corporation, the employees become part owners of the corporation’s capital, and also share in the profits of the business through the payment of stock dividends. Also, in theory, the corporate management team can be held responsible by a legal fiduciary responsibility to the employee shareholders. This is what is commonly known as principal-agent theory, where the management team acts as an agent in the interests of the principal, or shareholders.

However, somewhere between theory and practice there is a disconnect. While workers share in the ownership of company as stockholders, and retain the voting rights of all shareholders, they do not have a direct say in the management decision making. Their say in management decision making is via proxy through the elected board of directors. Shareholders have a percentage of votes equal to the percentage of shares they own, so if the majority of shareholders agree that the management are performing poorly they can elect a new board of directors, which can then hire a new management team. In practice, however, genuinely contested board elections are rare. Board candidates are usually nominated by insiders on the management team, and by the board of the directors themselves, and a considerable amount of stock is held and voted by both the board members and the management team. The employee shareholder’s voting rights often represent such a small percentage of the total that they can be considered negligible.

Ultimately, those who most influence the direction of a company are the management team, the board of directors, and the large institutional investors that hold and manage the employee shares in mutual funds. Each of these three constituencies have different motivations, and incentives.

The Management Team

The management team of any large corporation is tasked with both short term and long-term decision making to support the mission of the business and deliver the financial results demanded by the investors so that they may realize a financial return on their investment. Unlike a Democratically elected government, the management team is not a group elected by the vote of equals. In addition, unlike a family owned business, the management team is not selected based on class, or family connections. Instead, the management team is a group of leaders that have risen to positions of management through their promotion by higher-ranking managers within the organization. The focus of the professional manager as an agent for the shareholder is improving efficiency. The motivation is to maintain continued investment through the increase in share price. The management teams of most large corporations have a significant amount of their financial compensation in the form of stock option grants. Therefore, an increase in share price will directly affect the material wealth of the management team.

The Institutional Investor

In the United States at the end of 1992, institutional investors held at least 50 percent of the share capital of large corporations. I believe that figure has grown in the last 17 years. As the owner of the capital the institutional investor is free to purchase, hold, or sell the stock of any given publicly traded company in the interest of creating profit for the shareholders of the mutual fund. Institutional investment firms employ professional fund managers to manage the stock portfolios in line with the investment strategy (long-term growth, international growth, moderate growth, or securities).  While Institutional investors are legally the principal “owners” of the capital they invest, in reality the fund manager is acting as a trustee of the money belonging to the mutual fund shareholders. The mutual fund manager is not a principal, but merely an agent for the shareholders of the mutual fund corporation. Mutual fund companies earn their profit by selling individual shares in their funds, and charging fees to their customers for the management of the stock funds. The typical investor in mutual fund stocks, are individuals who purchase the stock either using their own money, or through company supported 401k and retirement pension funds. As the market value of a mutual fund stock is directly related to the performance of the fund, the institutional investor is highly incentivized to maximize his return on investment by buying stock in companies that show growth in earnings. To the institutional investor, the only thing that matters is the near term financial performance of the company in which he invests.

Our Board of Directors

The Board of Directors

The third constituency is the board of directors of the corporation. The boards of directors are professional managers from other organizations that have been elected to sit on the board, and protect the interests of all shareholders. Board members are elected by shareholders to represent their interests. In this role, the board members serve as the acting principals for the shareholders. In practice, most board members are chosen from among the peer group of the corporate management team, and boards are typically composed of either large shareholders, or professional managers from other corporations. The result is that the board of directors, and corporate management team become a self-perpetuating group of elite insiders. Both are financially compensated by the performance of the company stock, which is positively impacted by attracting the investment of large institutional investors. As described above, the best way to attract institutional investment is to deliver continuous growth in corporate financial earnings.

The irony in this ownership system is that the mutual fund stocks making up the largest percentage of a corporation’s shareholders are typically owned by many employee shareholders. These employee shareholders are employed by many different companies, and acquire their mutual fund stock through employee 401k retirement and pension funds. While financial returns are important to the individual shareholder, other concerns such as job security, working conditions, environmental impact, and long-term health benefits have an immediate impact on both their subjective and material well-being. The illusion is that making employees into shareholders through stock ownership & pension funds gives them a voice.

The rise of the mutual fund, and pension fund as the primary owner of financial capital has created demand for continuous growth and increasing profit to increase short term earnings per share.  The result is a paradox where the jobs held by employee stockholders in developed nations are eliminated in an effort to reduce operational costs related to salary and benefit expenses. By moving these skilled, and unskilled, jobs to developing countries the cost of producing goods is reduced, in pursuit of increasing the financial performance of the stock price, and creating profits for both the management team, the board of directors, and ultimately the retirement pension funds of the very employees whose jobs were eliminated. The new employees in the developing countries are not typically given access to employee stock ownership, or pension funds.

The result is a paradox where jobs are eliminated to secure the future retirement income of the employees holding them. This reminds me of the Vietnam era quote “We must destroy the village in order to save it”. Obviously, the current state of corporate governance under shareholder theory only holds management accountable for short term financial results. Clearly the gap between long term and short term incentives for corporate management teams do not serve the interests of all shareholders, particularly the employee shareholders.

Employee Shareholders hard at work in the Lair

Does this mean that all corporations are governed only for short term stock price gains? No, I am not cynical enough to suggest that. Yet. However, it is clear that the management team is only given short term incentives, and that any view to the long term stewardship of the corporation on their part is purely of a personal initiative and desire, and will not be rewarded by the corporate governance system. Is it any wonder we continue to see fraud, and ethical violations at publicly held corporations?

How can this system be changed? Well, currently the corporate governance laws are written such that unless a gross fraud is being committed on the part of management, or accounting laws are being violated, there is no recourse for shareholders to hold management accountable for the long term operation of a corporation. The only business models that I have seen have success in this, do not fall into the category of stockholder owned corporations. They are usually privately held, family owned business, or cooperatives owned solely by the coop members.

Until corporate governance laws are revisited in a meaningful way, the corporate overlords will continue their reign of darkness, and wage slaves like myself will continue to serve them in their nefarious deeds. Innocent people will continue to scratch, and claw out their living as a small part of a largely unjust machine, that seems to run on it’s own accord. Rare is the organization that is evil, or corrupt to the core. Such infamous folks as Madoff, Petters, Rigas, Skilling, and their ilk are thankfully rare.  When their pyramid shemes finally do collapse, their is always much hand wringing, and finger pointing, but seldom do we truly analyze the underlying structure of shareholder theory of the supposedly ethical corporations.

What is truly scandalous is the corporate governance system that we have created, which concentrates the power and wealth in elite circles. It is this system that encourages and rewards the self serving behavior of corporate management teams, and drains the wealth and capital from the communities in which we live. It is shareholder value which feeds the beast of globalization, and lines the pockets of the few, at the expense of the many. If only this kind of evil had a face, it would be so much easier to fight. Instead we are powerless against this faceless, formless, Leviathan of a corporate system. I fear that not even the power of government can control this transnational beast any longer. James Bond, where are you?

My Villianous Liege

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