shareholders

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Shareholders and Public Trust?

I remember sitting at business school what seems a lifetime ago and absorbing with enthusiasm the latest financial trickery. It seemed so much more rigorous than all the other stuff. I felt as if I was being taught something incisive, something with intellectual heft, something that was not subject to the whim of subjective belief, but was, rather, grounded in solid theory.

Boy, was I wrong.

Somewhere in the middle of all that mumbo jumbo was the notion of shareholder value. Here we were being taught that the only purpose of a corporation was to return the most it could to its shareholders. That most big businesses were called a ‘public’ corporation seems an irrelevancy because the word ‘public’ was simply a device to distinguish it from the alternative: a ‘private’ corporation, which was a different animal altogether.

But that word public actually has a deep meaning. Especially when we consider the near total lack of ownership that the presumed owners actually possess.

I was prompted to think about this by a recent John Kay article in the Financial Times. Set aside the source. Think about the thoughts. Here is a good sample:

“Ownership, like friendship, has many characteristics and if a relationship has enough of them we can describe it as ownership.

If I own an object I can use it, or not use it, sell it, rent it, give it to others, throw it away and appeal to the police if a thief misappropriates it. And I must accept responsibility for its misuse and admit the right of my creditors to take
a lien on it.

But shares give their holders no right of possession and no right of use. If shareholders go to the company premises, they will more likely than not be turned away.

They have no more right than other customers to the services of the business they “own”. The company’s actions are not their responsibility, and corporate assets cannot be used to satisfy their debts.

Shareholders do not have the right to manage the company in which they hold an interest, and even their right to appoint the people who do is largely theoretical. They are entitled only to such part of the income as the directors declare as dividends, and have no right to the proceeds of the sale of corporate assets — except in the event of the liquidation of the entire company, in which case they will get what is left; not much, as a rule.”

This is all true. My own work experience confirms it to me. Shareholders exist on the periphery. They do not exert control in any true meaning. They simply expect a return. And that return is manipulated by management to match whatever the current market fad wants it to be. Shareholder returns are administered cash flows  managed to conform with socially acceptable levels. The social pressure setting those ‘required’ returns exists within a narrow and self-contained financial circle that includes Wall Street and its various adjunct professional and media tributaries.

There is no solid ground under the notion of shareholder value at all. The entire concept exists in mid-air.

Yet business has been beholden to it for the best part of four decades. Innumerable workers have been fired in order to ‘release’ shareholder value from underneath the pedestrian boot of ‘inadequate’ management. Entire sub-cultures  and business groups have sprung up around the idea of shareholder value. More damage has been done to the lives of American workers by the notion than by pretty much any other idea.

Modern finance, within which shareholder value plays a central role, has much to answer for. It sits atop an entirely false premiss: that shareholders own the corporation. No they don’t. Not in any practical way. And certainly not in any way that distinguishes them from any other group wanting to exert ownership rights. Like the workers who comprise the workforce. Or the managers who dictate what the business does. Or the customers who buy the products and thus provide the demand to keep the business alive. Or the boards of directors who sign off on that cashflow the shareholder so crave.

How did this total misrepresentation come about?

Well you probably know.

Like many other errors in modern economic life Milton Friedman and his Chicago progeny plays a large role. He was blunt in arguing that the only reason corporations exist is to maximize shareholder returns.

How economists love that word ‘maximize’. As if maximization in the real world was possible. Having sat within the confines of a large business, and having tried to apply modern finance in a practical way, I can assure you that the idea of maximization is laughable. Quite where the necessary information is coming from to allow for it, I have no idea. Presumably from some set of infantile assumptions. Like the ones in mainstream economics.

The fixation of mainstream economics with maximization and other engineering concepts is easy to understand. It allows for a precision of thought and, more to the point, an accuracy of calculation, which, in turn, can then be twined together into elaborate and elegant explanations of how the economy works. The only cost for all this wonder is that the world around us has to be ignored. Because in that world none of that accuracy, precision, elegance, or elaboration survives its first contact with uncertainty and the limits of information.

Economics has been undaunted and unaltered by its lack of reality. Unfortunately when some of its pioneers started to create modern finance they blithely imported the lack of reality along with their zeal for mathematical elaboration. What appeared to me as a business school student to be nifty rigor and a theory of great practical import, was in fact a sham, built as it was upon the same sand as mainstream economics. No, not sand, that is too substantial: modern finance floats free like its economics counterpart and makes sense only at some altitude well above the somewhat more cloying earth we prowl about day to day.

So we ought chalk up some more real world damage to hold economics accountable for. Not only did it screw up the economy by trying to re-work the real world in its own image, but it exported its silliness into finance which then abetted in that re-working.

Between the two economics and finance have managed to mangle the lives of a multitude of people. I am not sure we can reform economics easily: it is too self-absorbed and self-congratulatory. So we need to start with its application in the offshoot of finance.

There has been a lot written about the vagaries of what we teach and learn at business school: the relentless ideological content gives students a very blinkered view of the alternatives. And, yes, there are alternatives. Robert Locke, who is a familiar name when it comes to a critique of ‘western’ business school teaching recently sent me a paper he gave on the topic. Read it to get the flavor of what our students are missing. Whether we agree or not, we have to realize that management is not the single minded pursuit of shareholder value. Nor can it be if the shareholders do not actually own much at all.

So: get rid of economics at business school, after all nothing could be more amusing than watching students embrace modern micro-economics in one class and then learn how to defeat the market in the next. As for finance: ditch shareholder value and go back to the previous theory that a modern corporation is a public trust. With that last word having all its many meanings.

Oh. And that might even get big business out of politics.

Trust. Really?

Well I can dream can’t I?

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Ken Lewis Must Go!

Alright I admit that’s a bit harsh. But he’s done nothing but foul up lately. The Bank of America shareholders meeting next week, on the 29th of April, should be a fun one to sit in on.

It appears that our indomitable Ken was coerced by Hank Paulsen, then Treasury Secretary, into going ahead with B. of A.’s takeover of Merrill Lynch even though revelations about the awful state of Merrill were becoming known to the bank’s executives. Apparently Lewis, a banking empire builder par excellence, was getting cold feet at the prospect of having to absorb Merrill’s balance sheet, stuffed as it was with a myriad unpleasant surprises. All of which were costly. Having sold his shareholders a bill of goods with his ‘opportunistic’ acquisition of Countrywide, whose corrosive book of sub-prime mortgages was already eating its way through B. of A.’s income, Lewis realized that taking on Merrill would most likely sink the bank entirely.

So he baulked.

Paulsen reacted with his best Goldman Sachs swagger, and read Lewis the riot act. Basically the message was: go through with the Merrill deal or the government will oust you as CEO. After all B. of A. was already a basket case by then and on the taxpayer dole, so combining with Merrill was only going to make a dead bank deader. It wasn’t going to kill a live bank.

Naturally Lewis saw the light. B. of A. went ahead with the deal, and we, the taxpayers, have been supporting it with ever more fervor ever since. We absolutely love B. of A.. Or at least we must in view of all the money we give it.

So now Ken has a problem.

It seems that some of his shareholders have awoken, and to their horror have discovered that the Merrill deal has not gone supremely well from their point of view. In fact it appears to have destroyed that part of whatever shareholder value had managed to survive the Countrywide deal.

Ken’s acquisition record is not too good just now.

These pesky shareholders now appear to believe – how could they? – that they have the right to oust poor old Ken. The nerve of these shareholders! There is nothing worse in all of corporate America than shareholders who think that management should be working for them and not the other way around.

I digress.

Lewis, having buckled and done his patriotic duty even though it clobbered his own shareholders pocket books, now has to face those shareholders and explain why he chose country over company.

That’s an ugly choice. Especially since his legal obligation is to the company.

So much for patriotism. Perhaps Ken can insulate himself by wearing a flag pin at next week’s meeting.

All of this is now roiling Washington. It is Andrew Cuomo mischievously supplying copies of all the correspondence that provide details of Paulsen’s strong arm approach and Lewis’ capitulation. It makes for great political theater. But it also raises a tough point: just how much can the government expect a private company to act in the public interest?

Obviously, had Lewis acted solely on his shareholders behalf he would have walked away from the Merrill deal. That would have left Paulsen in dire straits because Merrill would almost certainly have gone the way of Bear Stearns, only on a much larger scale. As Paulsen apparently put it to Lewis: there was a risk of systemic failure had Merrill gone belly up. In the heat of the moment the only viable option Paulsen had was to force Merrill into B. of A. regardless of the damage it did to the bank. There was no time to get shareholder input, and in any case, given the leaks about Merrill’s condition, the shareholders would most likely have rejected the deal had they been asked.

So the government effectively pushed B. of A. closer to the brink of insolvency, knowing it was going to have to bail it out anyway, rather than risk the liquidation of Merrill on the open market.

Paulsen probably also calculated that poor old Ken was going get the heave ho sooner or later. B. of A’s executive team has managed to destroy too much shareholder wealth for them to survive for long. So given that Ken’s demise was a matter of time, Paulsen must have thought he could use Lewis’ fear of being fired for his own, and the country’s, best ends.

So the conflict of interest between public and private interests has caught Lewis in a vice. He came through with flying colors from the public’s perspective, although that won’t do him any good when he faces his shareholders.

Was Paulsen right? Should he have coerced a CEO to act against the interests of his shareholders? Given the options there wasn’t much choice. I give Paulsen a pass on this one. It was Lewis who could have pressed for a better deal from the government. As it is: B. of A. is one of our weaker banks and will need long term support to nurture it back to health. It probably needs breaking up so that it is no longer ‘too big to fail’. That would undo about eight years of Ken Lewis empire building.

The taxpayers owe Ken for taking on Merrill. B. of A. should fire him nonetheless: his empire building will have produced nothing but the erosion of wealth for its shareholders.

It’s a tough life being a bank CEO.

Ken Lewis must go!

Addendum:

This story is now exploding in importance. Friday’s Financial Times pursues it aggressively and lists all the documents you need to read.

The timing of Cuomo’s release of documents means that shareholder pressure on Lewis is bound to escalate rapidly. His chances of survival are looking slim right now, although it isn’t at all clear how much of his executive team also needs to go. Perhaps Paulsen’s strategy all along was to force the shareholders to clean house, so the fact that Cuomo’s investigative team suddenly send such inflammatory documents to Congressional committees right before the annual shareholder meeting may not be a coincidence after all. Then again the implication of that is an unusual level of cooperation between people like Cuomo and Paulsen, neither of whom seem to me to be the kind of people who willingly share the limelight.

In any case Ken Lewis, who’s leadership of B. of A., has been terrible, now has his career in jeopardy. His record says he deserves this moment. I only wish it had arrived through the normal course of corporate governance, and not through what appears to be a highly contrived and possibly politically motivated maneuver by Cuomo’s office.

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Is America Capitalist?

This is a question that is vexing me greatly right now. In a more pure capitalist system the linkage between capital, the investors in business, and management, the custodians of that investment, is straightforward. And results oriented. The message to management is obvious: make the right return or be replaced. This pressure to perform is, according to the textbooks, what drives the machinery of innovation and efficiency.

This current crisis has, however, demonstrated just how different our economy really is from this ‘ideal’ state.

Managers run companies largely without reference to shareholders. Or, more accurately, shareholders are now passive rather than active forces in the corporate structure.

There is nothing new in this. The literature is full of references to the ways in which management is now a profession – MBA schools have burgeoned in the past few decades – and of how the increasing complexity of business has rendered active participation by shareholders in the affairs of corporations ineffective. Stuff is just too hard for the average shareholder to understand so it’s better to leave it to the pros.

Over time the control that shareholders actually assert over their investment has eroded to near farcical levels. Besides which most investors nowadays are strictly stock purchasers: they have no intention, or conception, of ‘owning’ a company. Instead they view stock as an asset alongside other assets such as bonds or real estate.

And their appointed guardians, the Boards of Directors, have connived at this deterioration. Indeed if the evidence of this recession is anything to go by the average Board is nothing but expensive window dressing.

The shocking destruction of shareholder value in banking is a case in point. The huge drop in share prices as the incompetence of management was exposed by accumulated losses has scarcely raised the ire of any of their boards. Instead of wholesale firings and reorganizations we get small scale adjustments and cautionary words against rocking the boat at moments of delicate activity. The glacial pace of change at Citibank, whose stock has lost 90% of its value, is hardly a ringing endorsement of the vibrancy of capitalism. It smacks of something closer to Soviet era bureaucratic self-preservation.

Executive pay is at the center of this failure. Shareholders were evidently misled by bank managers for a while. The business model most banks adopted was adroit only in creating an illusion of wealth while insiders like CEO’s and high level traders extracted vast amounts of loot for themselves. Once the game was exposed the shareholders were left with a devastating diminution in their wealth while the perpetrators of the illusion walked away with mountains of cash.

The linkage between investor and control of their investment could not have been more clearly severed.

The redistribution of wealth from shareholders to managers amounts to wholesale pillage.

And if you think this is an academic matter consider your own retirement fund. Most of us have our money managed by an investment manager who is supposed to exercise fiduciary responsibility, not just to produce the gaudy annual returns they all advertise in their glossy brochures, but also to protect the original investment. Investment management is, or should be, a conservative, careful, and above all respectful activity. The protection of capital being foremost among its aims.

Where were these people?

Why were they not berating management and the boards? Why are they still not demanding stern action and perhaps even restitution? Why did they sheepishly vote to support management and director re-election year after year?

Because they are all interconnected. Many banks are themselves money managers. Many other money managers deliberately avoid confrontation with management, presumably on the basis of ‘professional courtesy’. Yet others are simply too small or lazy to undertake proper due diligence for their investments.

Boards are all a maze of relationships: my board has many of your board members. CEO’s patrol each others flanks and defend the brotherhood rather than get tough. Insiders dominate many boards. Outsiders are carefully chosen as figureheads or as meek followers. Very few act as independent watchdogs. If they do, they get replaced.

Furthermore, the network of advisors who could provide cautionary words have become mere shills for the stock market companies they all seem to work for. And it turns out that the rating agencies – Moody’s; Standard and Poor’s etc – were paid by management to rate assets favorably.

In other words the entire system upon which investors relied to protect their money failed. No. More than failed: it was complicit in the pillaging of wealth.

Naturally the really large investors, those who can employ their own analysts, did better. They could buy a board seat and therefore ask the awkward questions that no one else seemed willing to. But that only helped them.

What about the average retiree? Who looked out for them?

No one.

And this is where I become truly angry: only a few years ago we were being bombarded about the privatization of retirement investment. The virtues of capitalism were touted as a being so strong that the government sponsored retirement system was positioned as failing the average family: retirees were losing a fortune because he or she could not participate in the great game of capitalism through Social Security.

To think that all those folks would have had to place their money at the mercy of the exact industry that has just failed so spectacularly.

So is America capitalist in any true sense of that word? Or is it simply corporatist? Is it a vast interwoven network of bureaucrats whose objectives all coalesce around their own bonus pay?

The whole notion of our being a nation of investors is patently absurd if we have no mechanism through which to assert the rights of ownership.

The Reagan era deregulation swept away most of the protections investors had against potential looting by managers. The idea was to return us to the gilded age of capitalism. The problem was that the second coming of the gilded age was one of management, not capitalism, because there are very few large private companies any more. The new plutocrats are the executives of JP Morgan, not JP Morgan himself.

The funny thing is that economics has a whole theory – ‘Agency Theory’ – that exactly covers all these issues. They teach it at business school. Or at least they did in my day.

No wonder those clever MBA’s know how to game the system.