Burgess COMMENTARY
LinkedIn Comment Peter Burgess ... Founder/CEO at TrueValueMetrics developing Multi Dimension Impact Accounting

I am glad to see articles like this ... but it frustrates me that this issue has been talked about for 5 years, or is it 25 years and really not very much changes.

When I was a corporate CFO some years ago, I was always careful to correlate the talk about performance and the numbers about performance. There is a lot of talk that does not convert into action of any sort ... and the grim reality is that the majority of investors and C level decision makers are doing value maximizing of financial capital, and taking little or no interest in all the other capitals that ought to be part of the computation of performance.

I argue that until we change the way the metrics are done, taking into consideration all the capitals and not just the financial capital, we will continue to have decisions that are bad for people, for society and for the planet.

Peter Burgess

The Financial Times Slams 'The World's Dumbest Idea'

Good news! The Financial Times has come out forcefully against maximizing shareholder value. The article declares that we have made a mess of the way companies are run.

“Almost nothing in economics is more important than thinking through how companies should be managed and for what ends. Unfortunately, we have made a mess of this. That mess has a name: it is ‘shareholder value maximisation’. Operating companies in line with this belief not only leads to misbehaviour but may also militate against their true social aim, which is to generate greater prosperity.”

The article’s author, Martin Wolf, is the associate editor and chief economics commentator at the Financial Times and is often said to be “one of the world’s most influential writers on economics.” Among his supporters, writes The New Republic are “Larry Summers: ‘[Wolf] is probably the most deeply thoughtful and professionally informed economic journalist in the world at this point.’ Harvard economist Kenneth Rogoff: ‘[Wolf] really is the premier financial and economics writer in the world.’ Mohamed El Erian, CEO of PIMCO, the world’s largest bond investor: ‘[Wolf] is, by far, the most influential economic columnist out there.’” Wolf himself says that he is “writing for the people who are …running these things, both governmental and politicians and financiers.” IMAGE MartinWolf2011 By DaphneBorowskiCC BY 2.0 via Wikipedia

One hopes therefore that all these influential people will listen to Wolf’s denunciation of the still pervasive view that the purpose of a firm is to maximize shareholder value—an idea that even Jack Welch has called “the dumbest idea in the world.”

Shareholder value mis-allocates risk

Wolf’s principal critique of shareholder value maximization is that it misallocates risk.

“The economic argument for shareholder value maximisation and control is that, while all other stakeholders are protected by contract, shareholders are not. They therefore bear the residual risk. This being so, they need to control the company in order to align the interests of management with their own. Only then would they be prepared to make risky investments.

“Yet, while shareholders do indeed bear risks in their role as the insurers of solvency, they are not the only stakeholders to do so. A host of others are also exposed to risks against which they cannot be fully protected by contract: long-term workers; long-term suppliers; and, not least, the jurisdictions in which companies operate. Moreover, shareholders, unlike others, and particularly employees, can hedge their risks by diversifying their portfolios. A worker cannot normally work for many companies at the same time and nobody can hedge employee income by owning shares in other people, except via taxation.”

The market economy has changed, fundamentally

“The doctrine of shareholder value maximization,” Wolf writes, “has allowed us to believe that the existence of these long-lived, hierarchical and powerful entities has not changed the market economy fundamentally.” Not so, says Wolf.

The market economy has been changed fundamentally by the existence of large corporations, and the shareholder value theory has aggravated the worst aspects of the change. “A company whose goal is whatever seems profitable today can be trusted only to renege on implicit contracts. It is sure to act opportunistically.”

Does the solution lie in different governance?

What to do? The article surveys various governance solutions, including those proposed by Colin Mayer of Oxford’s Saïd Business School and his book, Firm Commitment:

“a ‘trust company’ one with explicit values and a board designed to oversee them,” or “divergent structures of control. One might be to vest voting rights in shares whose ownership can be transferred only after a holding period of years, not hours.” However even Wolf himself seems to doubt whether these changes in governance structures will work. Instead he suggests that we “recognise the big trade-offs in managing and governing these complex, vital and long-lived institutions.”

Shareholder value is a goal, not a governance structure

The key to the solution may lie in seeing that shareholder value primacy cannot be solved by different corporate governance alone. Shareholder value in essence is not a system of governance. It’s a goal. It’s one possible concept of the purpose of the firm. It is guide for decision-making by everyone in the organization. It reflects the values that drive the firm’s actions on a day-to-day basis. If there is something wrong with the purpose of a firm, it cannot be fixed by a change in the governance system. It has to be replaced with a different, and better, goal. It is only when we have the right goal that governance can work properly.

Generating value for shareholders is a possible result of a firm’s activities, not the goal. In fact, pursuit of shareholder value as a goal has succeeded in systematically destroying real shareholder value, through unwise share buybacks, massive offshoring of manufacturing, undermining US capacity to compete in international markets and killing the economic recovery.

Nor is it a matter of tradeoffs between conflicting goals, as is sometimes suggested. As Roger Martin points out in his chapter in the recent book, Making Capitalism More Inclusive, “It is unhelpful to promote the existence of a trade-off between shareholder value maximization and benefit to society, and then plead with managers to trade the former off for the latter. This simply entrenches the self-fulfilling prophecy and makes it harder to dispel. Instead, proponents of inclusive capitalism should argue that the trade-off is not inherent; it is a product of the model in people’s heads. The core task of management is not to choose between shareholder value maximization and benefit to society; it is to seek creative resolutions that enhance both.”

In fact, a consensus is already forming around a better version of the purpose of a firm that does exactly that. That’s the big news coming out of a recent report from the Aspen Institute which convened a cross-section of business thought leaders, including both executives and academics. The report’s most important finding is that majority of the thought leaders who participated in the study, particularly corporate executives, agreed that “the primary purpose of the corporation is to serve customers’ interests.” In effect, as Peter Drucker pointed out back in 1973 in his classic book, Management, the best way to serve shareholders’ interests and society is to deliver value to customers.

The many supports of shareholder value primacy

Governance is important, as Wolf points out. The governance system of a corporation reinforces the overall company direction, fundamental strategies, executive compensation systems, values and ethical standards. When talking about good management, it is essential to talk about governance.

But governance is only one part of the many arrangements in our society that support and reinforce the misguided goal of maximizing shareholder value. Seeking to find a solution to the problem of shareholder value must go beyond governance and look at all the sources of support that hold the “the world’s dumbest idea” in place, despite its catastrophic economic consequences.

Executive compensation plays a key role, since with the current arrangements, executives have huge financial incentives to take actions that will increase the share price in the short term. In the period 1978 to 2013, while the rates of return on assets and invested capital in US firms declined by around 75%, CEO compensation increased by an astonishing 937%, while the typical worker’s compensation grew by a meager 10%. As Upton Sinclair noted long ago, “It is hard to get a man to understand something when he is being paid not to understand it.”

Corporate compensation committees are also critical. We cannot expect the C-suite to act differently when multi-million dollar bonuses are dangled in front of them by compensation committees to act irresponsibly. As Bill Lazonick has recommended in this month’s HBR, stock-based pay should be reined in. “Overall the use of stock-based pay should be severely limited. Incentive compensation should be subject to performance criteria that reflect investment in innovative capabilities, not stock performance.”

Cronyism and reciprocal rent-seeking. Thus in a recent study published in the Accounting Review, an astounding 62% of directors, who had a disclosed friendship with the CEO, said they would cut the budget for research and development in order to assure the bonus for their friend, the CEO. The leadership values that support and condone such value-destructive behavior must change.

Stronger and wiser CEOs are needed. While former CEOs, like Jack Welch, are often strongly critical of shareholder value after their departure, some CEOs are now speaking out, while still at their posts. In 2013, Paul Polman, the CEO of Unilever [UN] has declared that it is “time to put an end to the cult of shareholder value.” In July 2014, Xavier Huillard, the current Chairman and Chief Executive officer of Vinci in France declared at the Drucker Forum launch in Paris: “To say that our enterprises belong solely to our shareholders is totally idiotic.”

Chief Financial Officers often act as guardians and watchdogs of “the single objective financial function” by which shareholder value is enforced in decisions taken throughout the whole organization. Every decision and action is evaluated in terms of its impact on short-term earnings per share. The financial function needs to be redefined so that it takes into short-, medium-and long-term interests of the organization. As Clayton Christensen has argued in HBR, different analytic tools need to be used.

Strategy also needs to be reinvigorated to play its proper role in defining the proper balance of activities, with short-, medium- and long-term payoffs. In recent years, corporate strategy has tended to be discredited, as a result of the exercises that were popular in the late 20th Century–massive backward-looking data-driven exercises, which were slow and costly and which shed little light on imminent transformational change. By default, maximizing shareholder value tended to replace real substantive strategic thinking and contributed to the disproportionate attention to the short-term, at the expense of real value for shareholders in the medium- and long-term.

Regulators are also part of the problem. When many big corporations are involved in value-destroying activities on a regular basis, then the challenge for regulators is not one of responding reactively to spot the odd individual wrongdoer, but to think proactively as to how to inspire change in the way of doing business that is deeply flawed. This is a challenge for instance that the SEC, for instance, has yet to undertake.

Investors need to be educated. Investors themselves must learn that chasing short-term gains is short-sighted. So long as they focus on, and reward, short-term gains in quarterly earnings, without regard to the fundamentals of how those gains were generated, they are not only engaging in predictably irrational behavior: they are reinforcing conduct that will soon undermine those very returns.

Share buybacks need to be identified as stock manipulation and outlawed, as Bill Lazonick has recommended in his seminal article in HBR. Thus between 2003 and 2012, publicly-listed firms in the S&P 500 used a colossal amount of their earnings—54% or $2.4 trillion—to buy back their own stock. Lazonick’s article reveals that this wasn’t done for the most part when stock prices were low: astonishingly, most of the big purchases came when the stock price was high. Why? “Because stock-based instruments make up the majority of executives’ pay, and buybacks drive up short-term stock prices.” These firms are engaged, the article says, in “what is effectively stock-price manipulation.”.

Institutional investors have a particular responsibility in showing the way forward and refraining from participating in behavior dictated by short-term moves in the share price.

Politicians have an important role to play. Thus in July 2014, President Obama gave verbal support to shareholder value theory. Instead of lending support to “the world’s dumbest idea,” political leaders should, as Doris Kearns Goodwin argued in her new book “The Bully Pulpit” be acting like Theodore Roosevelt in the US in the early 20th century and using their voices to build up the momentum for reform. We need political leaders who have the understanding and courage to speak out.

Business schools have a responsibility to stop teaching shareholder value in their core curriculum to their students and start systematically teaching the better idea: the primary purpose of the corporation is to serve customers’ interests. Business schools must recognize that it is not enough to teach Customer Capitalism as an optional subject. Textbooks that teach shareholder value theory as a basic assumption must be discarded.

Analysts and the press have a responsibility to focus not just on the daily ups and downs of the market but also to analyze what is the underlying basis of its performance. Is the stock on fire because of genuine strong performance, or is it financial engineering of the worst kind? This kind of analysis is rarely heard now from analysts. It needs to become the norm.

Rating agencies must also clean up their act. The rating agencies were complicit in condoning and even rewarding some of the riskiest practices in the 2008 meltdown; they received significant compensation for doing so. They must take a harder look at the noxious consequences of share buybacks, particularly when funded by anomalously cheap borrowing.

Obviously, this is a vast agenda involving the goals, values and actions of many people and institutions all around the world. New governance structures for corporations could contribute to the solution but, even if they could be implemented, they are not enough. We also need to recognize that a much wider and deeper set of changes are needed, starting with agreement on a different purpose of the corporation, namely, to serve customers’ interests. In effect, the best way to serve shareholders’ interests and society is to deliver value to customers. Time to wise up.

And read also:

From CEO Takers To CEO Makers: The Great Transformation

Why The World’s Dumbest Idea Is Finally Dying

Why IBM Is In Decline

The best new books on the Creative Economy

The five surprises of radical management

Follow Steve Denning on Twitter @stevedenning

Assistance in preparing this article included comments from Roger Martin, Richard Straub, Bill Zalonick, Rod Collins and Robert Randall. The views expressed in the article are the author’s own.