Tag Archives: public interest capitalism

The case for restricting stock buybacks

William Lazonick makes the case against stock buybacks in the latest issue of BusinessWeek.  In his article “The Buyback Boondoggle“, He argues that companies spend huge sums of money on buybacks that they could have invested in innovation and employment.  From the article:

The amount of money spent on buybacks is staggering. From 1997 through last year, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on them. In 2007, as profits soared, the average buyback bill for each was about $1.2 billion—a record amount. And faced with a dramatic drop in their combined net income in 2008, these companies trimmed buyback spending, but not proportionately: The buyback-to-profit ratio, which was already unprecedented in 2007, more than tripled in 2008, from 0.90 to 2.80.

He further observes that buybacks helped weaken major American firms to the point that they required government bailouts when the economy deteriorated:

If bailed-out General Motors (GM) had banked the $20.4 billion distributed to shareholders as buybacks from 1986 through 2002 (with a 2.5% aftertax annual return), it would have had $35 billion in 2009 to stave off bankruptcy and respond to global competition.

And the bailed-out banks? Eight of the biggest spent a total of $182 billion on buybacks from 2000 to 2007. That reduced their ability to cover their bets on derivatives, exacerbating the crisis they created in the first place.

At the heart of the issue is the conflict of interest between shareholders and management, on one hand, and other corporate stakeholders such as employees, customers, suppliers, local communities, and nations, on the other.  Shareholders have limited liability, so they can profit by extracting as much money from companies as possible during good times, even to the point of taking on debt to pay dividends–a common private equity practice.  If the companies subsequently go bankrupt, the shareholders have already pocketed their profits.  The greater the likelihood of bankruptcy, the greater the incentive for shareholders to take money out.

A more subtle problem is that shareholders have difficulty quantifying and verifying the value of long-term investments, so they prefer short-term investments or cash distributions.  Thus managing for shareholder value becomes managing for the short term, leading to underinvestment in innovation, human capital, and organizational capital.

As Lazonick points out, executive compensation in the form of stock shares and options create incentives for senior managers to buy back shares, since buybacks both distribute cash to shareholders and increase demand for shares.

In the article, Lazonick proposes banning share buybacks, but this won’t solve the problem of short-termist incentives embedded in executive compensation linked to stock price.  So how about limiting the value of stock grants and options to 5% of base salary for employees of publicly traded companies?

From hired hands to higher aims?

Over the last several decades, maximizing shareholder value has become widely accepted as the duty and legitimate purpose of business managers.  Many scholars propounded this ideology, and probably none more forcefully than Milton Friedman.  In a well-known article in the New York Times Magazine in 1970, he argued that “The Social Responsibility of Business is to Increase its Profits“.  In his book From Higher Aims to Hired Hands, Harvard Business School professor Rakesh Khurana describes how this view replaced a conception of the business manager as a steward of the public interest responsible for skillfully balancing the interests of corporate stakeholders to sustain the enterprise and create value for society.  William Lazonick and Mary O’Sullivan provide a complementary perspective.

Unfortunately, while maximizing shareholder value squares nicely with neoclassical economic theory, it can cause serious problems in practice.  In my research project on Public Interest Capitalism, we link shareholder value maximization to inequity, short-termism and underinvestment, and deterioration of social capital.  In a nutshell, there are three fundamental problems with relying on shareholder value maximization as the criterion for corporate management.  First, market incentives (hence profit) may correlate only slightly or even negatively with social welfare (on this point, see David Grewal’s book Network Power).  Second, markets can impede innovation (Mary O’Sullivan provides the details in Contests for Corporate Control).  Third, by reducing the purpose of the company to generating as much profit as possible for a diffuse external constituency, shareholder value maximization decrease the identification of employees to organizational goals, thereby hindering learning and efficient operation.  For a different but complementary perspective, see Simons, Mintzberg and Basu’s “Memo to: CEOs“.

Fortunately, it appears that the shareholder value maximization movement may have run its course–albeit after bringing the global economy to the brink of collapse.  A group of MBA students at Harvard Business School, concerned about business ethics and inspired by Rakesh’s work, have started MBA Oath, a movement to professionalize management.  The New York Times has the story: “A Promise to Be Ethical in an Era of Immorality“.  This is a very encouraging development.

Chinese capitalism

The Los Angeles Times is reporting “China relaxes business regulations“.  The article describe government efforts to prevent laws and regulations from hampering business:

The Industry and Commerce Administration of Zhejiang province … earlier this year released what local media called the “three noes” policy. Two of the noes have to do with minor licensing and registration issues. The third one, though, states that there should be no punishment for businesspeople who make “common violations that don’t directly cause harmful consequences.” Instead they should be given suggestions and admonitions to correct their errant behavior, officials said.  …

In China’s southeast industrial hub of Guangdong province … the government cautioned investigators about detaining or taking other action against entrepreneurs or key company managers that could disrupt business. Even if authorities have gathered all the evidence, action may be delayed until the manager has finished conducting business.

On the environmental front, there is evidence of regulatory capture:

In China’s southeast, Jiangxi Copper Corp. is expected to begin work next month on a $730-million lead-zinc smelting operation along the Yangtze River.  … Jiangxi province’s environmental protection bureau boasted that it had finished the environmental-impact review in just three days

According to the article,  favorable treatment for capitalists is nothing new:

Even during ordinary economic times, giving privileged policies to businesspeople in China is common.  Some smaller locales have offered investors immunity for traffic violations and other misdemeanors.

It’s easy to see how these policies could boost economic growth in the short term by removing constraints on business activity.  Whether these policies serve the broader public interest, however, seems questionable.

A Public Interest Capitalism perspective raises three questions.

  1. Are these policies sustainable?  Even leaving aside concerns about environmental destruction, economic theory gives us compelling reasons to believe that the rule of law is essential to advanced economic development.
  2. Are these policies equitable?  Perhaps investors and entrepreneurs merit special privileges.  I tend to think not, but the US tax system gives preferential treatment to capital gains.  Policies that relax regulatory enforcement are particularly problematic from an equity standpoint, however, because they benefit most those who are profiting from illegal, socially destructive activity.
  3. Will these policies promote innovation?  To the extent that these policies protect incumbent businesses, they create obstacles for creative destruction.  This may not be too much of a problem when the economy is growing rapidly and generating entrepreneurial opportunities, but it could hinder readjustment when growth slows.