Tuesday, 24 July 2012

Changing the Incentive Structure of Anglo-American Corporations

There is a clarion call to reform aspects of capitalism in order to address the problem of financial instability - an economic externality which has resulted partly from short-term financial behaviour and overleveraged institutions and sectors.  Professor of Law at Case Western University, Lawrence E. Mitchell, says in a recent piece that a significant cause of the financial crisis has been the disappearance of corporate equity funding and its replacement with debt over the course of the 20th century, debt which has more recently been off the balance sheet. Furthermore, he explains, sources of capital gains have shifted from profits reaped through retained earnings to future profits in the form of velocity-induced trading gains. Professor Mitchell asserts that the very sustainability of American industry and the future wealth of America are at risk when shareholders or mangers on their behalf gamble with debtholders’ money, spending today the future profits of American industry.

Since about 1962, common shareholders in the US have actually withdrawn more money from corporations than they have invested – this is apparent from the disappearance of retained earnings from corporate balance sheets and trends in net issuance of common stock. By 2002, retained earnings had dropped on average to 3% (from 50 to 60% from the beginning of the 20th century until the early 1960s), returning to 11% by 2007. Retained earnings which had represented permanent stockholders’ equity were replaced by debt, much of this off-balance sheet financing.

Shareholder capitalism is based upon laws, which in turn were based on principles of economic utilitarianism, which place ultimate control or a corporation in the hands of shareholders who elect the board of directors; it’s the stockholders as the residual claimants of corporate wealth who are meant to bear the greatest risk. Professor Mitchell says that trends in the debt/equity ratio have actually resulted in investment in corporate America which is almost nil and that the real riskholders are the creditors.

Thus we have the dangerous anomaly of boards and managers managing for shareholders (with shareholder interests in stock price maximisation and shareholder taste for risk) with creditors’ money.  This ability to use other people’s money for shareholder profit creates powerful managerial incentives to short-change the long-term health of the corporation for short-term gain, putting the American productive sector at risk…pre-crash (2006), over 30% of the profits of American corporations classified as ‘industrial’ came from financial transactions rather than the production of goods and provision of services.  And financial assets constituted almost 48% of the total assets of non-farm, non-financial corporations.[1]

In order to protect the sustainability of American industry and its ability to create permanent and transferable wealth, Professor Mitchell recommends that incentives are created for investors to reap the rewards of their investments through industrial profits rather than market speculation.  His specific suggestions include the following:

  • building long-term investing into the initial investment decision by developing a sliding scale capital gains tax
  • returning to largely insider boards
  • making appropriate accounting changes to rely more heavily on cash flow than income statement accounting.

Professor Mitchell, along with Professors Lynn Stout, Martin Lipton and Margaret Blair are the most well-known of the ‘board primacists’ – a group which advocates against greater ‘shareholder democracy’ in favour of increased board discretion. They argue that shareholders need to delegate their authority in order to allow the board to manage the enterprise free of short-term pressure. They believe that facilitating shareholder democracy and shareholder power would create greater costs than possible benefits. Board primacy theorises that because shareholders are a heterogeneous group, their objectives are not uniform; therefore they believe corporate law requires re-theorising in light of this new reality.

On the other hand, there has also been a groundswell of support for greater shareholder education, communication and involvement among some corporate governance academics who base their thinking on the claim that the board primacists conflate two aspects of the processes by which group decision are taken; these two are the responsiveness of the governance system and the composition of the shareholder electorate. Professor Grant Hayden of Hofstra University and Professor Matthew Bodie of Saint Louis University are two who say that because of this association, board primacists are arguing for governance structures that put greater distance between the shareholder electorate and the board which could have serious negative consequences.

Hayden and Bodie believe that by restricting the decision-making franchise,” board primacists have detached their governance structures from the underlying desires of their constituents without substituting anything in their place.”  They argue that “the breakdown of this particular distinction between shareholders and constituents could mean that we should investigate treating other constituents [variously defined but typically include shareholders, employees, suppliers, customers and creditors, sometimes expanded to include neighbours, towns or society ]more like shareholders, rather than the other way around.” [2]

Andrew Clearfield of Investment Initiative corporate governance consultancy is also a voice on the side of responsible shareholder involvement, being himself a former portfolio manager.  He believes that because shareholders are widely dispersed, management can behave as if they were the principals of a company rather than its agent.  Professor Stout says that when managers behave in such way, it’s difficult to bring them to heel; hence her preference for insider boards.  Mr. Clearfield says, “and unfortunately, history is replete with examples where exactly this has happened, to the detriment of shareholders (and often almost everyone else as well).”[3]   

He describes the fact that there are both short-termist, high-turnover shareholders who dislike the idea of shareholder activism in governance but that there are also shareholders who take significant positions and actively work to foster change from inside a company, remaining involved for many years:

There are governance-oriented investors who engage actively with their holdings not because they are planning to flip them, but on the contrary, because they expect to be involved for the long haul.  There are short-term investors who are essentially arbitrageurs, and who try to hide behind a mask of concern for governance, when all they really want is to stimulate an event or transaction which will enable them to exit at a profit.  And there are all sorts of shades in between.[4]

Mr. Clearfield challenges the assumption which board primacists make of director and senior management benevolence; he says that an emphasis on options incentives – which were not implemented on the insistence of shareholders – have often become detached from reasonable performance criteria and that managers have found various ways to game the release of favourable results and pricing of their share options.  The homogeneity of boards is another red flag Clearfield and many others cite as a problem for corporate governance: “Directors constitute a sort of club united not only by social ties but also by mutual economic interests.  They sit on each other’s boards and do not make waves….they become followers rather than leaders.  That should not be their function.”[5]   He cites boardroom duplicity for the failures of GM, Kodak, Hewlett-Packard, BP and Enron. 

Like many corporate governance reformers, Mr. Clearfield advocates shifting corporate focus  to the long-term by changing terms of executive incentives (to vest over longer periods with clawback provisions for illusory results), ceasing to give analysts earnings guidance and abolishing quarterly earnings statements (as John Kay recommends here in the UK).  “Make the market cool its heels and wait for longer term results, and it will have to take a longer-term perspective.”

The board primacists are concerned about short-termist investors or the few hyper activists who desire to micro-manage a company.  For Mr. Clearfield, the danger isn’t that the majority of shareholders will take their lead from the few prominent activists, but rather that they won’t pay enough attention to corporate governance to even bother to vote out a board which manages disastrously.  This is the scenario that has been more of a concern to those with a more macro view of public outrage over corporate fraud, corporate governance reformers like Lord Myners and the government.   Though the system has been prone to abuse by the short-term interests of the opportunists, “incumbent boards and managers who have large positions in the equity themselves are guilty of this at least as often as dispersed shareholders.”[6]

The board primacist professors, Stephen Bainbridge, Margaret Blair and Lynn Stout argue that if boards were able to take decisions free from shareholder pressure, they would make better choices about how the firm should be run.  Professors Hayden and Bodie refer to these commentators as ‘wise ruler’ theorists because they attribute the board with great acumen and invest them with great power; critical to board performance, they claim, is their independence and insulation.   Hayden and Bodie have a different take; they say that the goal of the corporation is not just shareholder wealth maximisation but that the directors owe a duty to the constituents of the corporation, which consist of all stakeholders including shareholders, employees, creditors and the local community.  According to this model, stakeholders contribute their resources to the enterprise with the implicit bargain that the company itself will fairly apportion responsibilities and rewards. [7]  The board is hired by the stakeholders to serve as the apportioning body; it is an agent, but has authority over stakeholders in order to carry out its function.  So in actual fact, the role of the board is more of a trustee than an agent.

Two board primacists, known as the “long-term interests” theorists include Professors Lawrence Mitchell and Martin Lipton who are critical of the short-term perspective of shareholders but their concern is more to do with the long-term efficiency of the corporation.  Professor Mitchel proposes self-perpetuating boards with complete freedom from shareholder oversight which he believes would enable them to manage responsibly and for the long term.[8]  In this model, shareholders have a limited role but election time would become a time for a more meaningful vote on the company’s future. 

If shareholders are left with even less power in corporate governance than they already have today, the corporate good may become more detached from the actual preferences of the firm’s constituents.    Hayden and Bodie argue for a radical change: they say that with respect to their preference profiles, shareholders are more like other corporate constituents than once thought:

Instead of focusing on the fact that shareholders are now as ‘bad’ as other constituents for the purposes of corporate governance, we could view this as evidence that the other constituents are just as ‘good’ as shareholders, a least in this respect.  That is, the breakdown of this particular distinction between shareholders and other constituents could mean that we should treat the other constituents more like shareholders rather than the other way around.

They therefore suggest expanding voting systems to include other constituents besides shareholders.  And though they recognise that there may be difficulty in arriving at an accurate and manageable way of identifying specific members of a constituency, like customers, for an election, ‘the breakdown of the fundamental distinction between shareholders and other constituents should at least force a re-examination of the scope of the corporate franchise.“[9] 

These suggestions would be a major step in the transforming (or returning) the current Anglo-American shareholder corporate structure into stakeholder capitalism.  There’s a powerful argument that such a change could usher in a more stable, efficient, sustainable and responsive corporate system with better informed, engaged and responsible investors.

[1] Professor Lawrence E. Mitchell, “Whose Capital; What Gains?” Governance Studies at Brookings, July 2012.
[2] Grant Hayden and Matthew Bodie, ‘Shareholder Democracy and the Curious Turn Toward Board Primacy,’ William and Mary Law Review, April 2010.
[3] Andrew Clearfield, “Short-termism and Corporate governance: Prof. Stout creates a straw man,” Investment initiatives, 12 July 2012.
[4] Ibid.
[5] Ibid.
[6] Ibid.
[7] Hayden and Bodie, 2010.
[8] Ibid.
[9] Ibid.

No comments:

Post a Comment