If capitalism is North America's secular religion, shareholder value is its creed, as fervently believed and proclaimed as any evangelical sermon. So it takes courage as well as independence of spirit for any North American, even a Canadian, not only to tackle shareholder value head on, but to finger it as the bane of capitalism rather than its unchallengeable foundation stone. All the more so as Roger Martin, whose important new book Fixing the Game does all this, is also dean of a business school (Toronto's Rotman School of Management), an institution which collectively has played a primordial role in legitimising the concept and now has a huge research and theorising investment sunk in it.
It's precisely the strength of the book, the most authoritative statement of what's wrong with our current model that I've seen, that it engages directly with underlying theory as the heart of the current problem. All the official reactions to the current crisis start from the assumption that we're playing the right game: we just need to tighten up the rules and play it better. By contrast, Martin correctly identifies that it was the fundamental assumptions that got us into trouble in the first place, so that basing their remedies on them politicians and regulators are simply doing the wrong thing righter, which ratchets up the wrongness. So while such fixes by definition won't prevent further crises, they will focus energy and resource in the worng place just when we need them most.
Using the example of the highly regulated and shiningly successful US National Football League as a counterpoint, Martin demonstrates how unintended consequences have turned shareholder value into a grotesque self-parody. The catalyst was a famous 1976 article by academics Michael Jensen and William Meckling which crystallised growing concerns that fat and complacent managers were paying more attention to their own interests than those of shareholders. The authors termed it an ‘agency problem’: a missing alignment between shareholder-owners (principals) and managers (agents). To make managers think like owners, what better solution than to load them with stock options that would reward them when the company did well and punish them when performance fell off?
Jensen and Meckling's much-cited article invented agency theory, anointed shareholder-value maximisation as the sole purpose of the corporation, and set a framework for corporate governance that has been used ever since. (It is faithfully reflected in the City codes, for instance.) Yet the strength of its influence is matched only by its malignity.
As Martin demonstrates, stock options were chips that turned executives into gamblers whose compensation was conditional on performance not in the real world but in the ‘expectations market’ of the stock exchange. Like any gambler with large stakes, managers did everything to change the odds in their favour – manipulating earnings to match expectations, massaging expectations to match earnings, until ‘many companies focus more on their stock analysts than their customers.’
There’s more. In a striking chapter on managerial ‘inauthenticity’, Martin shows how acting more and more in the abstract world of expectations, executives all too often lose contact with both the real world and their moral bearings. The result: on the one hand, customers, employees and relationships become instrumental and disposable means to the sole end of winning a zero-sum game; on the other an unprecedented wave of corporate fraud as managers cross the line into immoral and illegal behaviour, culminating in the scandals of 2008. (In the week I’m writing this, JP Morgan has agreed to pay $154m to settle a civil fraud case and along with RBS is now being sued for $800m by the US credit union regulator for mis-selling of mortgage-backed securities.)
As the final straw, volatility created by the artificially stimulated expectations market has attracted a new kind of market player, the hedge funds, that exist solely to exploit and even create that volatility. Hedge funds, as Martin sharply points out, generate no net value for society; indeed with their egregious ‘2&20’ fee structure, they lumber it with a heavy parasitic cost burden.
Have shareholders actually benefited from this slavish attention to their interests? Well, no. Crunching the numbers, Martin shows that in the period of shareholder ascendancy since the Jensen and Meckling article, shareholders have actually experienced poorer returns than in the four decades previously when managers were supposedly ripping them off – 6.5 per cent a year compared to 7.5 per cent.
Laid bare, the unclothed emperor is not a pretty sight. Shareholder-value maximisation and stock-based compensation have had the reverse effect to the ones intended, destroying shareholder value and aligning executives not with shareholders but with their own pocket-books. Executive pay per dollar of profit made has rocketed. The theories have driven damaging short-termism, fostered a- and immoral executive behaviour, and benignly favoured the mushrooming growth of parasitic players in the expectations market to whose tune real-market actors are increasingly made to jump. The expectations tail is wagging the real dog. In short, warns Martin, these theories ‘have the ability to destroy our economy and rot out the core of American capitalism... The expectation game is beginning to destroy the real game, slowly from within’.
To reiterate, these bankrupt theories are the ones that form the starting point for the fixes proposed for the post-crunch banks. No wonder they are so feeble – they are business as usual in the most literal sense.
Martin argues that much more radical moves are necessary: destroying the expectations market by recasting theory to put customers rather than shareholders first, eliminating stock-based compensation to bring executives back into the real world, rethinking board governance, reining in the hedge funds (for which Martin reserves particularly sharp criticism), and aligning corporations with rather than against the public interest by placing positive purpose at their centre.
While all these are obviously right and necessary, Martin’s diagnosis of the ills is understandably stronger than his prescriptions for treatment. Even he doesn’t tackle a number of other outstanding and difficult issues. The most glaring is ownership, one of the most fervently-upheld components of the shareholder-value creed. Yet when high-speed traders own shares for nanoseconds and hedge funds borrow shares only to vote them for their own short-term ends, what does and should ‘ownership’ mean? Besides, notwithstanding the myth, legal researchers agree that shareholders simply don’t own companies, which are legal persons in their own right.
His analysis also has important unvoiced implications for conventional models of strategy (prop. Michael Porter). By implicitly pitching the interests of companies and their managers against those of society, these models have contributed powerfully to the managerial inauthenticity and alienation that Martin rightly identifies as a part of capitalism’s problem.
All these hint at the enormous inertia of vested interest that will need to be overcome if capitalism is to be saved from itself. Martin describes himself as ‘a long-term optimist but short-term pessimist’ (more sacrilege to capitalist fundamentalists). Without changes along the lines he specifies, the short-term prospects for the Western economies that are still in thrall to shareholder value are indeed grim. For the longer term we can only repeat (and believe) after him the famous quote from Margaret Mead which heads the final chapter of this angry and urgent book: ‘Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed it is the only thing that ever has.’ She'd better be right.