In Fixing the Game (2010), engaging with both theory and practice, Rotman Management School’s Roger Martin has written the sharpest, most authoritative account of what’s wrong with shareholder value as the organising principle for management and corporations. Instead of aligning executives’ interests with those of shareholders, he explains, it aligns them with their own pocket books and incentivises them to game the system rather than do the hard work of pleasing customers and nurturing employees.
Simon Caulkin: What do you see as the dangers to US capitalism, and what will happen if we don’t do something about it?
Roger Martin: A couple of things. One is the ‘rotting-out-the moral-core’ danger. I’m not saying we’re completely there, but we’re heading in that direction. Executives have to lead an inauthentic life in which they’re supposed to do the undoable [keep the stock-price constantly rising], so they do something that’s doable instead – which is managing for the short term, worrying about stock-market expectations, cashing in their executive compensation and then often doing it again someplace else.
What that does is turn customers and employees into pawns that can be sacrificed to the cause of the greater good of increased executive compensation. So there’s this game playing. Rather than pLaying something that’s serious and meaningful and gets everyone together towards a goal, employees having a meaningful goal to their lives and feeling that if they go on serving customers great, they will go on enhancing their lives, their jobs, and the size of company – instead of that they’re playing a game which has no good outcome, in fact they may find half their jobs cut because the CEO hasn’t met the numbers the market wanted. So there’s the rotting out of the core of meaning.
Then there’s the inequality problem, with CEOs and hedge fund managers making such absolutely gigantic amounts of money and the rest of middle America flat. I don’t buy the disappearance of the middle class, there’s no evidence of that, but there is this rising inequality. The situation is very clear. There are two kinds of inequality: the differential between 95th percentile and the 50th, ie the top and the middle, and between the 50th and the 5th or 10th, the middle and the bottom. People always think of the latter when they think of inequaility. But the gap between the lower and middle is incredibly stable: it’s the gap between the middle and the top that has increased dramatically, and that’s not good.
It’s the combination of the two things that’s the danger to US capitalism. The second precipitates disbelief in democratic capitalism as a way to operate, and former damages the functioning of American democratic capitalism – it functions badly.
SC: What you’re saying is that the current situation is unsustainable?
RM: Yes. We’re not in equilibrium, bobbing along nicely. The game is being gamed ever more seriously, the core is rotting and people are becoming more and more dissatisfied, yes.
SC: Do you see hope in other models of capitalism, like say the European or Japanese? Is part of your worry that US capitalism is subsuming all others?
RM: That’s right. Other liberal democracies, all of them to me are like American capitalism only less bod. In essence the democratic capitalist business world is led by the US and others follow its lead. The UK is a perfect example. Stock-based compensation is now pretty common in FTSE100 companies, less prevalent in the German Dax. It goes: US, Canada, Australia, the UK, New Zealand and then it cascades outwards in terms of how much they mirror the US.
SC: One of strengths of your book, I think, is that you delve into the theory, agency theory and so on, to explain how the shareholder-value and stock-compensation obsession came about, and its results. To me it’s a powerful message. But how do people in the corporate world react to it? Is it a hard sell?
RM: To be honest, it is, although not an impossible one. It almost requires a retail rather than wholesale approach. Earlier this year I did a keynote presentation on Fixing the Game to the International Centre for Pension Fund Management, a global organisation for big pension funds. When I was contradicted by a compensation consultant on the same panel, the representative of a big UK pension fund, who shall remain nameless, got up and said, ‘I get that you disagree, but what Mr Martin does is lay out the facts and you’re just blustering’. There were a lot of people asking the ‘yes, but’ questions, because they don’t want to believe it, but at the end I was getting comments like, ‘wow, we really do have to rethink things’.
But it’s going to be a long haul because the existing theory and model are so entrenched, so heavily entrenched – it’s like as night follows day that stock-based compensation is better for everyone involved, and you come along and say no it’s not? It’s so worldshaking to them that they don’t want to believe it, they want to say, no, that just can’t be.
SC: Does the idea of ‘shared value’, as advanced by Michael Porter in his HBR piece, answer the problem?
RM: I’m not buying shared value.
Here’s what I think: there are plenty of folk who share with me that we’re pro-business, in that we believe that business is an agent for good in the world, if not the major source for improvement of people’s lives – but they struggle to say that if business is force for good and it’s not doing as nearly as much good as we’d like, what has to happen, why is that the case?
To me, Michael Porter with shared value is imploring CEOs to be different than they are currently without having a diagnosis in behind it as to why it’s absolutely sensible and utterly unsurprising to see businessmen doing what they’re doing, ie the things that Porter doesn’t want them to do.
For me, it’s like telling frat boys to stop chasing sorority girls. I don’t think you can implore CEOs to pursue shared value when the fundamental system under which they’re operating essentially and powerfully encourages them to do just about the opposite. So I’m trying to go for the fundamental drivers. In all my research I try to ask why things are this way and not some other way and not come up with the answer that the people involved are stupid or evil. If you ask why CEOs do they jerk the share price around, why are they spending much more time with analysts than customers or employees, why is their tenure getting shorter, why is volatility going up and returns coming down – I’ve got to come up with a better answer than that all CEOs are evil. That never works for me as a compelling argument.
SC: Talk me through your notion of authenticity. It’s a factor that is usually left out of economic-based critiques.
RM: That makes my heart sing because it’s the chapter I’m happiest with and I do think it’s a different take on the problem. I started from options backdating, and for a real reason. It’s almost insane to have such totally, totally illegal (and illegal in so many ways) stuff going on and have it be so widespread. So are the vast majority of CEOs evil? No, but it’s a bad case of loss of moral compass, and it comes from living in inauthentic world. Not unlike the Crips and the Bloods, where as an initiation ceremony you have to go out and take a life – take a life. I mean it’s completely crazy, but that’s what you do, everyone does it, that’s what we do here. Once you’ve lost your moral compass, in the middle of the wood it’s hard to figure out a good direction. So in the case of options backdating, people said, ‘Well, this helps retention and shareholder value maximisation’ – because they’re in this very surreal world of manipulating everyone else’s expectations and taking advantage, of making everyone else a mark. In this world it’s easy for a CEO to ignore that it’s about real people, real employees, real customers – all this stuff is a background to a game that they know they actually can’t win, so all they can do in the short term is exploit people who aren’t as well informed as they are.
SC: So the tail of short-term expectations ends up wagging the real-world dog?
RM: Exactly right. I guess I’m least charitable about the hedge funds. They need the real game to work for them to make all their money, and they take absolutely no responsibility whatsoever for protecting the functioning of the real world. It’s just there to be exploited in whatever way possible – if we destroy it, so be it. If their trading patterns around subprime mortgages caused major institutions to fail – more than 12 institutions failed and had to be bailed out – the hedge funds just go, ‘Ladida, yes, I guess there is a bit of a problem, but it’s not mine – we just wrote a cheque for $2bn in personal compensation, so how bad can it be if the US economy goes under and goes into massive depression? I’ve got $10bn in the bank, I’ve got mansions everywhere, I can move out of the US and buy an island... The defence that we don’t care that we’re exploiting something that has to be here in order to be exploited is a twisted amoral world. And the worst of it is that it’s pension-fund money in the supply line, funding this kind of lunacy.
SC: So how do we get out of it?
RM: It’s not easy. It has to be a combination of things. Boards have to wake up and say that stock-based compensation is not a good thing. Repeal the Securities Act 1995 that allows earnings guidance to be given and make it dangerous for CEOs to talk to the Street. Chop the upply lines by disallowing pension funds from investing in things under ‘2 and 20’ payment structures… And this is a more fuzzy one, but we have to redefine the role of boards and get back to a world where directors are responsible for the corporation.
The Delaware courts have done just a dreadful job of moving us toward a world in which it is interpreted that the duty of boards is to equity stockholders. It’s not supposed to be like that, but slowly but surely it has migrated that way. Canadian commercial law is going that way too. Reverting to a very clear legal framework where boards are responsible for the corporation – these are all things that are necessary.
There’s no single silver bullet, and some of it has to come from behaviour. I wouldn’t want to legislate everything. But one thing would be getting rid of the 1995 Securities Act, which wouldn’t add anything, just take away an incredibly stupid law. The other is the pension fund thing. We do have fiduciary provisions. I learned this from a finance professor, that when mutual funds invest money on a performance basis, it has to be on what’s called a ‘fulcrum fee’, where the downside for the fund manager has to be as much as the upside. That is, the whole management fee down to zero and below is clawed back if there’s significantly bad performance. Why does this apply to mutual and not pension funds? If it’s good enough for mutual funds, to protect the small shareholder, why not pensioners?
SC: Since you wrote your book, we've seen the Arab spring, with people taking matters in their own hands. With rising dissatisfaction here, do you foresee a corporate equivalent – violence on the streets?
RM: I'm hesitant to bring too much of a parallel, because there’s a vastly different level of oppression: massively oppressed people struggling to gain a measure of democracy is a much bigger deal than reining in grasping hedge funds and CEOs. But that having been said, I don’t think it’s a completely illegitimate analogy: all systems require a sense of legitimacy to prosper, and if this legitimacy is undermined you’ll get more and more widespread activities that subvert it. This is why I like the example of the NFL, because they stamp out illegitimising forces with a steel-toed boot, so they don’t get subverting activity. If hedge funds can make ginormously supernormal profits by wrecking, absolutely wrecking, something on which they depend to make moneym with a cavalier attitude, do we think that’s legitimate? Lots of people would say not – big time.
SC: Running through the book is the comparison of the highly regulated NFL, where competition works much better in favour of the customer, with the unregulated baseball league, where competition works much worse. What are your feelings about business regulation?
RM: The whole regulation argument to me is just so shallow. Could someone remind me of a time or place in history where we had ‘no regulation’ – or show me a US industry that’s prosperous and creating jobs that hasn’t benefited from government investment and intervention? Pharma? Whoops, there’s gigantic government funding of research universities and schools of medicine. The internet? Whoops, invented by Darpa. In computer hardware and software, aerospace, it’s exactly the same thing. There is absolutely no such thing as a completely free market economy. There are just better or worse rules of the game, better or worse contexts set up by people getting together in a democracy and saying there are some rules that it’s useful to have. I have zero patience with the question do we want regulation or not. The only question is whether it is good or bad.
Similarly with the issue of high versus low tax. Let’s get it straight. There will be tax. The question is whether it’s smart or stupid. Sweden has high, smart tax, US taxes are low and stupid. In the US taxes are heaviest on things that are stupidest to tax, such as corporate income – it has some of the highest corporate taxes in the world. France is stupid and high: the stupidest tax system in the world and huge – really, really high on savings and investment, corporate investment that Sweden taxes superlow. Other things are taxed high in Sweden, but it’s smart tax.
So for me the question is how cleverly are we setting the rules of the game to cause it to be played in most productive way? The NFL has done a brilliant job of that and baseball a crappy one. And I think the analogy holds for business as a whole.
SC: Overall, are you an optimist?
RM: Yes. I can’t help myself! I think that sensible people making sensible arguments can get to where we want to be even if it seems revolutionary. I like the story of the treatment of peptic ulcers. Up to the 1990s the theory was that peptic ulcers were caused by excess stomach acid and the universal treatment was a bland diet and antacids. In the early 1980s, two whacky Australians called Marshal and Warren said, you know what, we don’t think so, we think the cause is bacteria, and we can treat it with antibiotics. They wrote scientific papers that were all rejected until Marshall said, screw this, I’ll grow an ulcer and cure it with antibiotics. So that’s what he did, he ingested horrible stuff that cause an ulcer and then he cured it. So they started getting their papers published, until about 10 years later people started saying, you know what, all this treatment, including tens of thousands of cases of ulcer surgery a year, is completely useless. And in 2005 Marshall Warren won the Nobel prize for medicine. It was the dominant theory that every doctor in the world subscribed to and it took two decades, but in the end it was changed. So there is hope. Yes, I’m an optimist.