Seeds of Scandal
Whatever happened to shareholder value?
"Perverse Incentives" by Edward Chancellor, in Prospect (June 2002), 4 Bedford Sq., London WC1B SRD, England.
Plain old greed may go a long way toward explaining the past year’s rash of spectacular corporate meltdowns and accounting scandals, but they also have their genesis in a flawed idea.
That idea is shareholder value, a product of the early 1980s, when American investors finally lost patience with a long period of underperformance by U.S. corporations, writes Chancellor, assistant editor of Britain’s Breakingviews financial commentary service.
After the Great Depression, "the priorities of leading businessmen shifted away from maximizing the profit of their companies, or their own fortunes; other goals, such as stability, continuity, and responsibility toward employees predominated." In 1984, Texas oil tycoon T. Boone Pickens upended the old order when he launched a takeover attempt of giant Gulf Oil, backed by innovative high-yield bonds floated by financial wizard Michael Milken. Pickens and later raiders promised to unlock the hidden values neglected by complacent "corpocrats."
Big business responded with the concept of shareholder value. The idea was to make managers more responsive to the interests of shareholders (who are, after all, the corporation’s owners). Chancellor sees several consequences: "a focus on the core business; the use of financial engineering to reduce the corporate cost of capital; an emphasis on the business’s ability to generate cash; the linking of managers’ interests to those of outside shareholders through the use of executive stock options."
While there were benefits to the new approach, Chancellor believes many of them have been exaggerated. Did the reformed corporations invest capital more efficiently? Return on equity rose from 17 percent to 22 percent during the 1990s, suggesting that they did. But corporations took on piles of new debt in the 1990s (partly to buy back shares and boost stock prices). Add debt to equity, and the returns shrink to 13 percent. In this category, as in others, Chancellor argues, corporations actually did better in the 1960s.
As we now realize, moreover, "the generous compensation of top executives with stock options has created an overwhelming incentive to manipulate earnings." It has had other effects: Unlike shareholders, options owners don’t benefit from rising dividends, but they do benefit from rising share prices. "In 1995, the amount of money spent on [stock] buybacks exceeded outlays on dividends for the first time in history," Chancellor notes. On top of that, corporations with their eyes on short-term changes in the stock market made many bad long-term investments. The markets cheered as European telecommunications companies paid billions for licenses to operate new 3G mobile phone networks—never mind that demand was unknown and the technology untried. Today, many of those companies are basket cases. "Markets are constantly testing and discarding new ideas," Chancellor says. "The corporate world moves, or should move, at a much slower pace."
How to get corporations moving slowly again? Less emphasis on profits and shareholder value would help. "Great managers are motivated by the pride they take in their work" rather than by money, Chancellor thinks. Paraphrasing management expert Peter Drucker, he concludes that profit "is not the rationale of a business, just the test of its validity."