Perverse Incentives
By David Shaw

Even if you think Milton Friedman launched ‘the dumbest idea in the world,’ nothing will change without some outside help.

What would you give to have purchased 1,000 shares of Amazon’s stock on Sept. 7, 2001 at $8.51, four days before the terrorist attacks on the United States? The fourth quarter of 2001 earned for Amazon its first “real” profit, after seven years in business, and four years as a publicly traded company — four years and 15 quarters of losses.

And what would you give, as a director of a publicly traded company, to be able to approve your management’s investments, experiments and “moonshots,” with the promise that for 15 quarters you wouldn’t be flogged by analysts and the business press, and pursued relentlessly by activists who claim a better approach for maximizing the value of your company — provided that at the 16th quarter you turned a profit?

These are nice dreams.

Your $8,500 investment in AMZN would be worth $1.9 million today. And perhaps you’d enjoy your job as a board member far more, and not spend so much valuable board time worrying about the potential Amazonification of your core business, because you might have been able to weather, as Amazon’s board did, the naysayers and short sellers of that company’s early years, in the name of patience and seven-year outlooks.

Today, there are half the number of listed public companies in the U.S. than there were in 1996. And while it’s easy to lay the blame on the increased costs and scrutiny created by onerous regulatory requirements, I think it’s more the function of the external forces which can cause entrepreneurs like Elon Musk to famously melt down and threaten to privatize — forces which focus solely on maximizing shareholder value.

It’s become common to denounce shareholder value as the driving force, and indeed, the only purpose, of the corporation. This concept, which Jack Welch in 2009 declared to be “the dumbest idea in the world,” was championed by the economist Milton Friedman in the early 1960s, and took hold with tremendous force in the 1980s. Martin Lipton, founding partner of the law firm of Wachtell, Lipton, Rosen & Katz, and investment giants BlackRock, State Street, Vanguard, among many others, are fighting against the short-termism that has come to characterize today’s corporation, but I doubt they will succeed without — dare I say it? — outside (read: government) intervention.

Sen. Elizabeth Warren’s proposed Accountable Capitalism Act takes a very controversial stab at one form of possible government intervention, and in my view, goes way too far and not far enough, all at the same time. Until the incentives built into today’s public company environment are changed, changing the composition of the board, and enforcing a consideration of stakeholder interest, will accomplish exactly nothing.

Here are just a few of the things that need to be addressed:

• Should the tyranny of quarterly reporting be continued? The President has publicly pondered reducing reporting to twice a year, but as long as a company’s share price is dependent on those reports and the outlook for the next period it will be really difficult to eliminate short-termism — in fact, it will be impossible. But without quarterly (or other frequent) reports, how will investors know how their investment is doing? Perhaps it’s not the frequency of reporting, but the incentives (tax and otherwise) to sell out at the first sign of “trouble,” that is the problem.

• How should boards deal with activist investors whose agendas are clearly not about stakeholders, but about their own short-term gain? Some activists have good points about improving a company, but not all of them do. Are their potential rewards tax-favored or otherwise incented in a way that defeats a long-term vision?

• What about short sellers, who have a vested interest in the decline of share prices—do they serve stakeholders? Should short-seller profits be taxed at a higher level?

Here’s a thought: How about a new class of shares that, like a CD, has its returns tied to length of holding, and perhaps has significant tax incentives for holding five years or longer, with penalties in terms of return and tax for selling sooner? That might help with all three problems listed above.

Until the perverse short-term incentives built into the system are eliminated or at least reduced, a board can’t even begin to address the short-term incentives they’ve created for their management teams, or their own incentive to “invest” in stock repurchases, rather than future growth. And while a board might nobly adopt ESG statements, and continue to increase the diversity of the board itself, how will that diverse board be able to govern differently in a financial environment that doesn’t care a whit about stakeholders and long-term value creation?

I think there are two distinct forms of capitalism in our world: real capitalism, which puts capital at risk to build and grow profitable enterprises, and vulture capitalism, which puts companies at risk to build short-term profits that have nothing to do with building anything of value, except to the vulture.

Friedman’s message may have been useful in its time, but that message ultimately has proven to be self-consuming and destructive to real capitalism. Companies can and should be able to compete in ruthless marketplaces, against ruthless companies like Amazon, without the 800-pound gorilla of self-serving “value maximizers” on their backs.

Who or what will get that gorilla to jump down?

I welcome your ideas and comments at dshaw@directorsandboards.com.

 


Issue: 
2018 Third Quarter

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