Category: Governance

Time to bury Milton Friedman?

Milton Friedman got a name check twice in today’s FT, on the letter’s page and in an article by Philip Delves Broughton on the facing comment page.  What was it that Keynes said about defunct economists?*

The first reference was in a letter from Philip G Cerny, Professor Emeritus of Politics and Global Affairs, University of Manchester and Rutgers University, writing in response to Jo Iwasaki who was calling for moral leadership to prevent behaviour like that revealed in the VW Dieselgate:

“The first mandatory prerequisite for company executives is maximum profitability, whether for the company as a whole or shareholders in particular, as Milton Friedman and others have so successfully argued. Culture comes a long way behind, and only comes into play if it actually contributes to profitability. In other words, there is an inherent structural conflict between profitability and the kind of moralistic behaviour Ms Iwasaki wishes to prescribe.

“On the contrary, there is in fact a deep culture of profitability that prevents other sorts of cultural values from working. Only factors outside the company — whether government regulations, the courts, consumer rebellion, strong public interest pressure groups or exposure to scandal (as with Dieselgate) — can be effective, and only then if they do not seriously dent profitability. That’s capitalism.”

The shortcoming in the Friedman perspective on which Cerny relies is the failure to understand that the primary driver for the company executive is self interest, rather than corporate profitability.  Corporate profitability is a driver of behaviour only to the extent that it affects self interest.  Self interest is a function of lifestyle preferences, reputation enhancement, job security, bonus targets and personal moral compass.  The challenge facing boards and investors, and indeed all those with an interest in how the company behaves, is how to align the interests of executives with their own.

The second reference to Milton Friedman is more insightful and comes in Philip Delves Broughton’s column, which is titled “American business is the master, not victim, of globalisation: If businesses saw more value in investing in US workers, they could have done so”. 

Delves Broughton addresses the prospects for bring offshored jobs back to the United States, as promised by Donald Trump.  Referring to Steve Jobs telling Barak Obama in 2011 that the jobs manufacturing iPhones wouldn’t be coming to the US anytime soon, he notes that manufacturing jobs are increasingly disappearing as automation takes over, and that Shenzen is way down the learning curve and now delivers quality that Apple would struggle to find in the US.  However, the principle point of the article is that

“….the best US companies had become brilliant at managing across borders and directing resources to where they generate the highest returns. They weren’t victims of globalisation. They were its masters and had become less and less American.”

Delves Broughton continues later in the article:

“If one accepts Milton Friedman’s argument that a corporation’s sole responsibility is to its owners, then one cannot find fault with these multinationals. They plant their flag where the money is. Their shareholders don’t want them playing the “Star Spangled Banner” in the boardroom. And while they may not directly be investing in American workers, they are generating returns for US investors who can reallocate their capital as they see fit. Mr Trump has done precisely this with his own business, investing in property deals far beyond US shores.

“But this is a fragile argument and Mr Trump is gleefully smashing it to pieces. He knows you cannot respond to stagnant wages and economic insecurity among the working and middle classes with the crystalline logic of a Nobel-winning economist. And he is threatening to perp walk before the press any companies that disappoint him.”

Offshoring in order to harness skills and low cost labour has probably generated greater benefits overall for the US population as a whole, as a consequence of lower prices, higher quality and, for that matter, returns to shareholders.  But Delves Broughton is right to challenge the shareholder value orthodoxy that is an expression of the Milton Friedman view of the world.  One of the consequences of this way of looking at, and describing capitalism has been the increasing inequality in US society that has fuelled American populism and landed the US, to say nothing of the wider world, with President Trump.

We can only hope that the resilience of American society and politics can withstand four years of a Trump presidency.  US companies face a challenging time, notwithstanding the appointment of representatives of large corporations to cabinet posts and promises of tax breaks, as the government tries to deliver on its promises to the rust belt.  One way of understanding their plight is to reflect on an excessive focus on the “crystalline logic of a Nobel-winning economist” (while, at the same time, being complicit in the way that top managers were being rewarded by boards composed of their peers at everyone else’s expense) and not paying sufficient attention to the wider constituencies, particularly employees, suppliers and the political world.

*”The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” The General Theory of Employment, Interest and Money (1936), Ch. 24 “Concluding Notes” p. 383-384

 

 

 

Worker representation on boards: not exactly a U turn…..

….. but a sensible course adjustment to avoid the rocks.

The FT reports this morning that “Ministers are looking at ways to water down Theresa May’s pledge to put workers on company boards by exploring more practical options that do not run the risk of holding back day-to-day business operations”. This specific part of the report can hardly be fresh news, since doubts were expressed in many circles, not just in this blog, about the practicality of the proposal and whether it would achieve the desired outcomes. But clearly the spin doctors have now decided that it is time to prepare the ground for a course adjustment.

After reporting on reservations held by Greg Clark and Philip Hammond, the FT article continues by commenting that “when asked about the proposals, Downing Street was less definitive about the exact form that worker representation would take….According to one aide, the detail has been difficult to negotiate….admitting that there has been ‘some disagreement’ within cabinet”.

The challenge facing Mrs May – who set out her commitment unambiguously and in identical words on two occasions, following her appointment and then at the Conservative Party conference – is how to avoid providing her critics with yet more evidence of flip flopping on policy. The FT reports “Another aide said that it was not the specific detail that mattered as long as the policy sounded reasonably similar to the original promise.”

There is a solution, described here after Mrs May repeated her commitment to worker representation at her party’s conference on 5th October, that addresses the criticisms of the proposal that it faced after she first made the commitment in July (25 July post).

“So what should she do? There is a way for her to secure representation of worker interests on boards without appointing worker representatives. Submitting the appointment of all directors to a vote of all employees, in the same way that they are subject to approval in a shareholder ballot, would demonstrate an equality between shareholders and employees. In practical terms, it would force chairmen, nomination committees and large shareholders to consider the balance within the board, demonstrate that the slate of directors represent the interests of the company as a whole, and avoid the nomination of directors to whom the label “toxic” could be attached and whose inclusion could result in rejection in the employee ballot.”

Full text of 5 October post

Right diagnosis, wrong prescription: Theresa May’s worker representation proposal

Just in case we weren’t listening in when she talked about worker representation on boards on becoming prime minister in July, Theresa May used exactly the same words (highlighted in the speech extract below) in her leader’s speech at the Conservative Party conference today:

Too often the people who are supposed to hold big business accountable are drawn from the same, narrow social and professional circles as the executive team.

And too often the scrutiny they provide is not good enough.

A change has got to come.

So later this year we will publish our plans to have not just consumers represented on company boards, but workers as well.

The risk when you same something exactly the same way twice is that you leave yourself without any wriggle room.

Her diagnosis isn’t too wide of the mark but the rush to the particular prescription suggests very shallow intellectual foundations. Mrs May’s proposal for worker and consumer representation on boards has already been challenged on the basis that it conflicts directly with the principle of the unitary board adopted in the UK, which means that all members of the board have the same responsibility for the interests of company – currently defined very broadly under section 172 of the 2006 Companies Act. Individuals appointed by whatever method (and this in itself is a potential source of contention) would inevitably face conflicts of interest between their responsibility to their constituency and to the wider interest of the company and the resolution of the interests of all its “stakeholders”.

However, it is good that Mrs May is committed to rebalancing the interests of the various parties – particularly workers and customers (but by extension surely she would include suppliers, certainly in the grocery industry) – with shareholders, and containing executive pay. I fear that the prime minister herself lacks both the appetite and opportunity to engage with a new intellectual model of the firm to help her decide how best to reform corporate governance. We can only hope that she is willing to instruct her advisors to seek out frameworks to provide a solid platform for reform. With such a framework, there is a great deal that can be delivered by soft power – exhortation and challenge from No 10 to change behaviour on boards, among the institutional investors few of whom have chosen to use the power they possess, and in the commentariat of academics and journalists.

There is currently an enormous risk that we will have reforms that either deliver unintended consequences or are ineffective. Brexit will clearly consume a vast amount of government attention and parliamentary time, but by repeating the commitment quite so explicitly, the prime minister was not flying a kite but making a commitment.

So what should she do? There is a way for her to secure representation of worker interests on boards without appointing worker representatives. Submitting the appointment of all directors to a vote of all employees, in the same way that they are subject to approval in a shareholder ballot, would demonstrate an equality between shareholders and employees. In practical terms, it would force chairmen, nomination committees and large shareholders to consider the balance within the board, demonstrate that the slate of directors represent the interests of the company as a whole, and avoid the nomination of directors to whom the label “toxic” could be attached and whose inclusion could result in rejection in the employee ballot.

 

Paul Polman, CEO of Unilever, on sustainability, purpose and living by his values

In the late 1980s, the buying and merchandising team I led at high street retail chain WHSmith launched a substantial new range of environmentally responsible stationery. It resonated with the personal values of the team, in short we believed that it was the right thing to do. We also argued that it would be good for the company and provide us with an edge over competitors, since it would be attractive to a significant number of our customers, would help us with staff recruitment since we believed that smart young people wanted to work for an environmentally responsible company, and would help enhance the wider reputation of the company with marketing benefits spilling over into other product categories and win sympathy for us in other ways, even to the extent, for example, of creating a benign audience in local authority planning decisions.

This weekend’s FT contains a profile of Paul Polman, chief executive at Unilever for the past seven years, who has taken an even bolder and more extensive approach to environmental responsibility. His leadership reflects an explicitly understanding of the diversity of market dimensions and that companies need to consider, a sense of that the purpose of the company reflects long term sustainability – of the company and the environment in which it operates.

His responses to his FT interviewers speak for themselves:

“P&G started in 1837, Nestlé in 1857. These companies have been around for so long because they are in tune with society. They are very responsible companies, despite the challenges that they sometimes deal with, all the criticism they get”

When Polman became chief executive of Unilever …. he said that he only wanted investors who shared his view that Unilever needed to shepherd the Earth’s future as carefully as it did its own revenues and profits…..“Unilever has been around for 100-plus years. We want to be around for several hundred more years. So if you buy into this long-term value-creation model, which is equitable, which is shared, which is sustainable, then come and invest with us. If you don’t buy into this, I respect you as a human being but don’t put your money in our company.”

The FT article explains that Sustainable Living Plan adopted by Unilever has not met all its targets, pushing back the date for halving its products’ environmental impact from 2020 to 2030 but it has reduced the waste associated with the disposal of its products by 29 per cent, with the aim of hitting 50 per cent by 2020.  It is not without its critics, but a report from Oxfam report on the company’s practices in Vietnam identified “a number of critical challenges in translating the company’s policy commitments into practice”, the charity’s latest Behind the Brands ranking, which looks at the top 10 food companies’ record on small farmers, women’s rights, the use of land and water and greenhouse emissions, put Unilever in first place, ahead of other leading consumer products companies.

The outcome has been good for the company’s relationships with investors. In the FT’s words: “while he told short-term shareholders to shove off, he delivered good returns to those who stayed. Unilever’s total shareholder return during Polman’s tenure has been 203 per cent, ahead of his old employer Nestlé and well ahead of P&G………. The company has also succeeded in attracting more long-term shareholders………before Polman’s reign, 60 per cent of the company’s top 10 shareholders had been there for five years or more. Today, 70 per cent have held their shares for more than seven years.”

It is also clear from the FT article that Polman has also adopted this approach to environmental sustainability because of its alignment with his personal beliefs, and that his belief that the wider purpose of the company (which he likes to an NGO) is a further illustration of his own belief that he should live his personal values in his corporate career. The Saïd Business School’s Colin Mayer, author of The Firm Commitment, tells the FT “He has demonstrated immense courage and vision in promoting a concept of the purpose and function of business that initially met with considerable resistance, bordering on hostility, from several quarters.”

Highlights from October 2016 Harvard Business Review

My two picks from the latest Harvard Business Review relate to two Escondido Framework themes: the way that executive teams have been the beneficiaries of the misunderstanding by shareholders (or, rather, their representatives on remuneration committees) of what motivates them and how the relevant market relationships work; and the need to think about employees as customers.

An article titled “Compensation, the case against long-term incentive plans” reviews the work of Alexander Pepper, set out in his book “The Economic Psychology of of Incentives: New Design Principles for Executive Pay (Palgrave Macmillan 2015). Pepper documents how pay for performance incentives, and Long Term Incentive Plans in particular, fail to work as proponents expected. The four reasons are summarised as follows:

  • Executive are more risk-averse than financial theory suggests
  • Executives discount heavily for time
  • Executives care more about relative pay
  • Pay packages undervalue intrinsic motivation

HBR’s review of Pepper’s work, in its Idea Watch section, comes not long after news broke in London on 22nd August that Woodford Investment Management was to scrap all staff bonuses, based on the belief that ‘bonuses are largely ineffective in influencing the right behaviours.’

The second article of interest is an article by Cheryl Bachelder, CEO of fast food franchise Popeyes: “How I did it…… The CEO of Popeyes on treating franchisees as the most important customers”. It’s not so much the lesson expressed in the article’s title that excites me, but an extract in the middle of the text that takes the message a stage further, recognising staff as customers:

At one point in my career, I was touring restaurants to talk to team members about the importance of serving guests well. I met a young man who was not excited about my “lesson”. He asked who I was. “I’m Cheryl,” I said. “Well Cheryl,” he said, “there’s no place for me to hang up my coat in this restaurant, and until you think I’m important enough to have a hook where I can hang up my coat, I can’t get excited about your new guest experience program.” It was a crucial reminder that we are in service to others – they are not in service to us.

Timeless themes in Galsworthy’s “Strife” (1909)

My mother in law and I have resolved the problem of the deadweight loss of Christmas (Joel Waldfogel, American Economic Review, December 1993) by giving each other a night out at the theatre, accompanied by her daughter/my wife. Whether last night’s trip to see “Strife” at the Chichester Festival Theatre was her gift to me or mine to her doesn’t matter, it was a great production and my first exposure to John Galsworthy’s insightful exposure of the fallacy of mindless short term focus on shareholder value, the importance of recognising the constraints on the firm of public opinion, and the pressures on the trade union to serve its long term interest over the pressures of the interested parties in the immediate dispute. Furthermore, themes on hand around corporate governance, the tension between external directors and a dominant shareholder chairman, and on the other (in the context of the current junior doctors’ dispute and the tensions within the British Medical Association) between the professional leadership of the trade union and the intransigent leader of the local workers’ committee, have a resonance in 2016 every bit as powerful as they may have had when the play was first performed in 1909.

Wikipedia provides a useful synopsis:

The action takes place on 7 February at the Trenartha Tin Plate Works, on the borders of England and Wales. For several months there has been a strike at the factory.

Act I

The directors, concerned about the damage to the company, hold a board meeting at the home of the manager of the works. Simon Harness, representing the trade union that has withdrawn support for the strike, tells them he will make the men withdraw their excessive demands, and the directors should agree to the union’s demands. David Roberts, leader of the Men’s Committee, tells them he wants the strike to continue until their demands are met, although the men are starving. It is a confrontation between the elderly company chairman John Anthony and Roberts, and neither gives way.

After the meeting, Enid Underwood, daughter of John Anthony and wife of the manager, talks to her father: she is aware of the suffering of the families. Roberts’ wife Annie used to be her maid. She is also worried about the strain of the affair on her father. Henry Tench, company secretary, tells Anthony he may be outvoted by the Board.

Act II, Scene I

Enid visits the Roberts’ cottage, and talks to Annie Roberts, who has a heart condition. When David Roberts comes in, Enid tells him there must be a compromise, and that he should have more pity on his wife; he does not change his position, and he is unmoved by his wife’s concern for the families of the strikers.

Act II, Scene II

In an open space near the factory, a platform has been improvised and Harness, in a speech to the strikers, says they have been ill-advised and they should cut their demands, instead of starving; they should support the Union, who will support them. There are short speeches from two men, who have contrasting opinions. Roberts goes to the platform and, in a long speech, says that the fight is against Capital, “a white-faced, stony-hearted monster”. “Ye have got it on its knees; are ye to give up at the last minute to save your miserable bodies pain?”

When news is brought that his wife has died, Roberts leaves and the meeting peters out.

Act III

In the home of the manager, Enid talks with Edgar Anthony; he is the chairman’s son and one of the directors. She is less sympathetic now towards the men, and, concerned about their father, says Edgar should support him. However Edgar’s sympathies are with the men. They receive the news that Mrs Roberts has died.

The directors’ meeting, already bad-tempered, is affected by the news. Edgar says he would rather resign than go on starving women; the other directors react badly to an opinion put so frankly. John Anthony makes a long speech: insisting they should not give in to the men, he says “There is only one way of treating ‘men’ — with the iron hand. This half-and-half business… has brought all this upon us…. Yield one demand, and they will make it six….”

He puts to the board the motion that the dispute should be placed in the hands of Harness. All the directors are in favour; Anthony alone is not in favour, and he resigns. The Men’s Committee, including Roberts, and Harness come in to receive the result. Roberts repeats his resistance, but on being told the outcome, realizes that he and Anthony have both been thrown over. The agreement is what had been proposed before the strike began.

Missing from the synopsis are some of the more subtle themes in Galsworthy’s text, including the recognition by Harness of the reality facing the company (that it will not survive if the strike continues and the men’s jobs are on the line) irrespective of Roberts’ concern for a wider struggle against “Capital”, John Anthony’s arguments about the primacy of the bottom line and his duty not to compromise, and the concern of the majority of the directors of the company for public opinion (and their personal reputations).

Linear programming and the theory of the firm – flashback to the 1950s

Exposure to linear programming while doing my MBA at Stanford informed the model of the firm that I described first in May 1980 in a paper for Steve Brandt’s seminar on strategic management and developed into a core component of the Escondido Framework.   So when I was told recently about Robert Dorfman’s “Application of linear programming to the theory of the firm” (Berkeley, 1951) and a collection of essays from a 1958 symposium at the University of Michigan edited by Kenneth E Boulding and W Allen Spivey titled “Linear programming and the theory of the firm” (New York, 1960), I thought I should take a look.

Both titles engage somewhat futilely in trying to extend the application of linear programming beyond its useful limits, and swamp the conceptual opportunity of applying a way of thinking about organisational problems with multiple constraints with the desire to created mathematical analytical models under conditions that are necessarily massively complex, non-linear, and dynamic.

Dorfman’s final chapter, on “Assumptions, Limitations, and Possibilities” highlights the limitations of the techniques that he explored in the previous chapters, particularly in relation to the static conditions under which the analysis might be undertaken, the challenges of coping with a dynamic and multi period condition, and with uncertainty. He effectively gives up: “There is little reason to hope that linear programming, or any other simple formulized technique will be able to comprehend this entire problem”. This probably still applies even in an age of massive computing power and ability to capture and interrogate “big data” that Dorfman could never have imagined. He did acknowledge that at the time of writing his book that “linear programming emphasises the physical inter-relationships of productive processes almost to the exclusion of the demand side”. My memory of studying linear programming at the Stanford Graduate School of Business in 1979 is that in this respect at least the commercial applications of linear programming had moved on the in following few decades. Ultimately, however, Dorfman retreats back into an assumption that linear programming could be best applied to managing and optimising internal processes, accepts that the practical applications will be limited in the short term, but remained hopeful, that “economists can rely on the mathematicians, the electronicists, and the statisticians to provide a practical tool.”

The final two essays in Boulding and Spivey’s collection move beyond the descriptions in the earlier essays of the mathematics of linear programming and how they might be applied to the activities of the firm. Interestingly in the context of a book about the application of linear programming, both end up focussing on the difficulty defining the objective function for the firm, arguing that firms seek to more than just maximise profits.

C.Michael White’s essay “Multiple Goals in the Theory of the Firm” reviews the thinking prevailing at the time about the various goals for the firm, both within the scope of profit maximisation (eg in relation to time horizons, to strategic considerations such as discouraging competitive market entry, and in relation to public relations). He cites AG Papandreou, suggesting that he had pointed out that “profit is simply one possible ranking criterion in a broader system of preference-function maximisation. Under perfect competition, profit is the only ranking criterion consistent with survival. In the absence of perfect competition the long-run survival of the a firm may be achieved best (or at least as well) through the maximisation of goals other than profit.”

White addresses the issue of the survival of the firm “The firm as a social and economic organization, like many other organisms, has a compelling urge to survive. More fundamental than the profit motive, the motive to survive is implicit in most decisions within the firm, though the possibility of organizational suicide should not be ruled out”. He later observes “Survival, including the consequent homeostasis concept (Boulding, Reconstruction of Economics, New York, 1950) is seldom an explicit primary goal of a firm but instead provide a pervasive set of limitations on other goals including profit.” However, White fails, surprisingly in an essay in a book about linear programming to close the loop that is embedded in the Escondido Framework model of the organisation as the occupying the virtual space bounded by its market interfaces with customers, capital, labour, other suppliers etc. But he goes some way in this direction, for example identifying later in the paper that “In most instances financial objective are evidenced as additional constraints on other objectives.

White’s summary is as good a description of the objective of the firm as any I have come across since embarking on this project in 1980: “The goals of firms represent a wide array of alternative objectives of which profit maximization is only one, although without doubt a most significant one. In those instances where firms strive to maximize profit all other aspects of the firm’s behaviour impose restrictions on this goal.” (He continues his summary by observing “The difficulty of estimating with accuracy the long-run prospects of a firm makes survival or homeostasis (when interpreted as a relative position within an environment) the most likely long-run objective.”)

Sherrill Cleland’s “A Short Essay of a Managerial Theory of the Firm” is an insightful attempt to move beyond what he describes as “the Traditional Firm”, a limited model developed from the work of Marshall, Chamberlin and Robinson in the 1930s and 1940s essentially seeing the firm as a passive respondent to conditions imposed by external markets for consumption, capital, labour, and materials, and the competitive industry structure. He describes how while economists were studying the operation of the market to understand the allocation process, businessmen were “developing a strong propensity to innovate in order to gain temporary monopoly control over market forces. As the businessman learned by doing, his propensity to innovate shifted to a propensity to monopolize and temporary monopoly became more permanent. The pattern of internal decision-making which he followed was designed to minimize the external constraints which had theoretically limited his decision alternatives. The initial managerial revolution, then, was an attempt by the businessman to control or influence the external forces (the product market and the factor market) that had been controlling and limiting him. That he was successful, and patently so, is evidenced by our antitrust laws. He wished to expand his field of choice, his set of alternatives, while simultaneously reducing the degree of uncertainty he faced.” He captures the different types of relationship with these external forces in the following figure, that distinguishes between those that the business accepts as given, those that provide a degree of restraint but are subject to influence, and the activities that the firm can reshape in response to its own decisions.

sherrill-cleland-restructured-firm

Cleland later proceeds develop his “Managerial Theory”, reflecting how the firm, operating in imperfect markets and consequently with options in terms of pricing and other parameters, is in a position to take choices about its internal operations, processes and outputs, and consequently is able to consider goals other than straightforward profit maximisation. He considers the possibility of satisficing behaviour, for example ensuring only that profit levels exceed the cost of capital and perhaps share the benefits of market power through spending on social responsibility programmes, and also minimax behaviour, for example by engaging in defensive pricing to secure long term contracts and thereby reduce uncertainty or discourage competitive entry.

Cleland further explores how decisions are made within the firm, and highlights to failure of traditional economic models of the firm to consider the role of the people within the firm, in particular the “manager-executive” in taking decisions, and in turn the way that the institutionalised processes, policies and procedures shape the way that decisions are taken, and the decision themselves. He also examines the firm as an information system, with flows both up and down the organisation, to provide the basis for decision-taking by managers and their execution of these decisions by subordinates.

In common with Dorfman, Cleland hopes that his essay is merely laying the foundations for further work, but I have been unable to establish whether he undertook further work in this field or whether this essay provided the foundation for the work of others. Nonetheless, a sentence in his closing paragraph about his “Managerial Theory” that deserves wider airing for its emphasis on “satisfactory profit” and the decision-making power of management: “The managerial theory of the firm considers the firm as an organized information system, intent upon a satisfactory profit level operating in an external and internal environment which allows the manager significant decision-making power.”

 

“Irresponsible behaviour in big business” – “Unacceptable face of capitalism” remastered?

A new wind is blowing down Downing Street. The leadership of the Conservative Party has skipped back a track, with a generation born in the 1960s whose ideas were shaped by the Thatcher era replaced by one born in the 1950s that emerged into political consciousness in the years of Heath, Wilson and Callaghan. The young Theresa Brazier – later to become Mrs May – was studying for her A levels when the first of these branded Tiny Rowland as “the unacceptable face of capitalism”.

Tiny Rowland was engaged in a battle with his own non-executives at Lonrho at the time, dismissing them as “Christmas Tree Decorations”. Theresa May is now sharing the popular outrage at the conduct of Sir Philip Green and Mike Ashley and calling for changes to address “irresponsible behaviour in big business”, in particular to protect the interests of employees and to challenge excessive executive pay. It is interesting to compare the targets of the two prime forty three years apart: Heath was criticising the chief executive of a company whose non-executive directors were standing up to him, whereas Theresa May’s challenge is to behaviour exemplified by a former chief executive who owned, or rather whose wife principally, owned the company, and a second chief executive who is a majority shareholder but who appears to have the chairman and board in his pocket.

Mrs May’s pronouncements, aided by such high profile cases as BhS and Sports Direct, help to change the climate. But is this sustainable, and are the solutions being canvassed the right ones? Philip Augar, writing in the FT on 22nd August, noted

In her last major speech before entering Number 10 as prime minister, Theresa May eerily echoed remarks made by the former Labour premier Tony Blair 20 years earlier: “Transient shareholders are not the only people with an interest when firms are sold or closed,” she said. “Workers have a stake, local communities have a stake, and often the whole country has a stake.”

Mr Blair, in a speech delivered in Singapore shortly before he took power, asserted that it was “time to assess how we shift the emphasis in our corporate ethos . . . towards a vision of the company as a community or partnership in which each employee has a stake”.

Augar went on to point out that “what had promised to be a defining philosophy for New Labour was scarcely heard of once he was in office”. Admittedly, section 172 of the 2006 Companies Act did shift the ground by requiring directors to:

have regard (amongst other matters) to—

  • the likely consequences of any decision in the long term,
  • the interests of the company’s employees,
  • the need to foster the company’s business relationships with suppliers, customers and others,
  • the impact of the company’s operations on the community and the environment,
  • the desirability of the company maintaining a reputation for high standards of business conduct, and
  • the need to act fairly as between members of the company.

Nonetheless, Augar’s point about lack of delivery is well made, given precisely the types of issue that the new prime minister has declared that she wants to address.

Her ambition to reform corporate governance is admirable. But are they right solutions?  The FT reports today (25th July):

The prime minister’s allies say that a package of measures to improve corporate governance are being drawn up and will be published in the coming weeks.

Mrs May this month promised to broaden the pool of non-executive directors, so that they were no longer drawn from “the same narrow, social and professional circles as the executive team”.

“If I’m prime minister, we’re going to change that system and we’re going to have not just consumers represented on company boards but employees as well,” she said.

The idea is opposed by some corporate leaders, who fear that “worker directors” would end up being selected by trade unions. Mrs May’s team say they would act as a deterrent to the “appalling” working practices adopted by Sports Direct, which were heavily criticised by MPs this month.

Mrs May’s reforms are also expected to include a requirement for more transparency on pay, including making shareholder votes on corporate pay not just advisory but binding. “Pay multiple” data would also be published to show the gap between a chief executive’s pay and those of workers.

The new prime minister has also talked about toughening competition law to protect consumers and a further crackdown on corporate tax avoidance and evasion. “It is not anti-business to suggest that big business needs to change,” Mrs May said at the launch of her leadership bid.

There is some very good stuff here, including ideas about widening the pool of non-executive directors, but a lot more thought is required about how this should be done, and what would be the most effective way of ensuring that what is done addresses the problems identified. For example, appointing a token employee director may be a less effective way of addressing the need to represent employee’s interests than having an effective workforce or HR director on the board whose job it to take into account the need to meet the needs and desires of all the workforce, and couple this with greater protection of employee rights, not least around working conditions and pensions.

“Shareholder value ……. the biggest idea in business” – Really?

The Economist has published a useful analysis of the place of “Shareholder Value” in contemporary thinking about business and the firm (Shareholder Value: the enduring power of the biggest idea in business*, The Economist, 2 April 2016).

The article describes the evolution of the idea that the purpose of the firm is to maximise shareholder value, its primacy first in the Anglo Saxon world, but its pervasiveness today globally wherever commerce is practised. It also cites the objections to capitalism of a society that sees corrupt and failing businesses and widening social inequality.

It describes the challenges faced by Shareholder Value. The first that is it

“is a licence for bad conduct, including skimping on investment, exorbitant pay, high leverage, silly takeovers, accounting shenanigans and a craze for share buy-backs, which are running at $600 billion a year in America”

but the Economist then argues that these are essentially perversions of Shareholder Value:

“These things happen, but none has much to do with shareholder value. A premise of “Valuation” is that there is no free lunch. A firm’s worth is based on its long-term operating performance, not financial engineering. It cannot boost its value much by manipulating its capital structure. Optical changes to accounting profits don’t matter; cashflow does (a lesson WorldCom and Enron ignored). Leverage boosts headline rates of return but, reciprocally, raises risks (as Lehman found). Buy-backs do not create value, just transfer it between shareholders. Takeovers make sense only if the value of synergies exceeds the premium paid (as Valeant discovered). Pay packages that reward boosts to earnings-per-share and short-term share-price pops are silly.

“Outbreaks of madness in markets tend to happen because people are breaking the rules of shareholder value, not enacting them. This is true of the internet bubble of 1999-2000, the leveraged buy-out boom of 2004-08 and the banking crash. That such fiascos occur is a failure of governance and human nature, not of an idea.”

The second is the challenge of the stakeholder model:

“that firms should be run for all stakeholders, not just shareholders. In a trite sense the goals of equity-holders and others are aligned. A firm that sufficiently annoys customers, counterparties and staff cannot stay in business.”

The Economist then goes on to describe the difficulty finding an objective to replace shareholder value, including risk of potentially unintended consequences of placing too much emphasis on specific stakeholder, for example by protecting employment to the point that a company goes under. It then concludes that “For these reasons shareholder value—properly defined—will remain the governing principle of firms” but with the qualification that “shareholder value is not the governing principle of societies. Firms operate within rules set by others.”

The Escondido Framework turns a lot of this thinking on its head. Maximising shareholder valuation is not an absolute objective: rather the management of a company need to deliver sufficient shareholder returns, including the prospect of returns, to secure the capital the company requires and to satisfy shareholder that they would not be better off using such influence as they have in the financial instruments they hold to replace them with other managers. This is fundamentally no different to the task they face setting terms of employment to secure the necessary workforce, and designing products and services and setting prices to attract and retain customers. The Escondido Framework also argues that other, non-financially mediated markets have also to be considered, to keep regulators on-side and to maintain a favourable climate among the public at large who may ultimately influence the behaviour of governments or even do such perverse things as consequence of their alienation as to cast votes to leave a continental economic union that underpins the welfare of the economy.

One of the underlying conclusions of the Escondido Framework is that shareholder value is not the governing principle of firms. This is a descriptive not a normative statement. Firms are managed to keep shareholders of management’s backs. Inefficiencies in capital markets and corporate governance result in perverse and/or satisficing behaviours by managers in relation to shareholders, as evidenced by the lack of control of executive salaries and value destroying M&A activity. Firms that are successful in the long term in terms of market presence, satisfying customers and being places that employees report as attractive places to work, whose standing and reputation with the public helps reduce pressure for adverse regulation from government, happen also to be those who are successful in providing returns to shareholders over the long haul that attract long term investors who, like Warren Buffet, manage to generate superior returns. The deal works this way round, not the other way!

*The authors regrettably seem unaware that Jack Welch once described Shareholder Value as “the dumbest idea in the world” – see blog post 10th April 2010