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Remember when American enterprise was the best the world? Sadly, that is changing. A little over a month ago, the venerable DuPont Company surprisingly won an epic battle over Nelson Peltz’s Trian Fund. DuPont, the company that brought us Cellophane, Neoprene, Teflon, Lucite, and so many other wonders of modern life had been forced into a grueling two-year fight for its life. Why? Because Trian, an “activist shareholder,” decided that by trimming research, selling divisions, and firing employees DuPont’s shareholders could make more profit more quickly. Although this time the company won, most companies don’t win. They either lose or capitulate. Battles such as DuPont’s are becoming widespread, and that is changing the nature and vitality of America’s public companies and the American economy.
Several decades ago I founded Rodel, Inc., a manufacturing company that eventually became global with plants spread around the world. It was the classic American success story. We started in a rented garage and built the company using retained earnings. Over time, we outdistanced our competitors and achieved such a high market share that almost every electronic device made anywhere in the world was made using at least one of our products.
The important factor enabling that astonishing success was that we were a private company whereas almost all of our competitors were public. That meant we could do things—make investments, take risks—that our competitors didn’t dare do for fear of inciting a shareholder action. Because our competitors had public shareholders, they were under pressure to maximize shareholder value, i.e. increase their stock price. Corporate actions that did not help immediate earnings, like investing in risky but potentially rewarding new technologies, were dangerous for a public company to undertake. Dangerous because such investments could lower earnings for a few quarters and invite “activist shareholders” to try to take control by claiming that the company was being mismanaged.
Yet the market we served, semiconductor manufacturing, needed just such adventuresome risk-taking. It was a rapidly developing, fast-moving market with frequent changes in manufacturing technology. The suppliers who won the competition were those that could move faster and take the risks necessary to meet those changing new technologies. Our public competitors, on the other hand, had to be more careful and justify to shareholders every action they took.
This situation has only gotten worse in recent years. Like DuPont, many of our finest public companies find themselves fighting for their lives, fighting their own shareholders.
American public corporations are a lot like the fabled goose that laid golden eggs. They, like the fabled goose, create wealth gradually, day after day, increasing the wealth of the nation. They are our nation’s crown jewels, the envy of other countries, a major source of jobs, and the engines that made America the most prosperous nation in the world. But in America today, like that goose, they are attracting some unwanted attention.
In that old fable, greedy villagers killed their goose and destroyed its ability to create future wealth. Our geese—our companies—also hold considerable wealth inside. That wealth is as necessary for their future as is a farmer’s seed corn. That wealth—retained corporate earnings—is what funds growth, research, new products, and helps weather a rainy day. But that wealth also represents an irresistible temptation for some so-called “investors” to buy in and harvest the wealth for themselves.
This relatively new culture of harvesting is supported by a number of beliefs—myths, actually—that make the gutting of companies more publicly acceptable. These beliefs have taken hold over the last four decades and have become generally accepted as truths in both boardrooms and classrooms. Although they are wrong, they are used by activists to rationalize harvesting now over investing in the future.
Here are three of the most pernicious myths:
Myth One: A corporation’s sole legal purpose is to “maximize” profits for its shareholders—even, if necessary, at the expense of employees, customers, the community, or the environment.
The facts: Not so. The myth was given credence by Milton Friedman’s 1970 opinion that the sole purpose of a corporation is to maximize profits. But Friedman’s opinion was just that—opinion. In fact, there is no such legal requirement. There is no law in Delaware or any other state requiring a corporation to maximize profits. Corporations are legally free to pursue long-term objectives even at the expense of short-term profits. Indeed, for a company to have a great future, it must have the ability to forgo some immediate profit in order to pursue long-term strategies.
Myth Two: When Activist Shareholders “unlock value” and distribute capital to shareholders, that capital is then free to be invested in newer and more vibrant enterprises.
The facts: It doesn’t happen. According to recent surveys of net capital flow, capital and “value” extracted from target corporations is not used for investment in new enterprises. In spite of the dramatic rise in capital distributed to shareholders, new capital invested in public enterprises has plummeted. Shareholders today trade capital among themselves and drive up the price of luxury assets (elite real estate, art, etc.) and the stock price of other companies. “Unlocked value” rarely finds its way back into productive enterprises.
Myth Three: Shareholders need more power for they are the only constituency that can act as a check on management excesses and inefficiencies.
The facts: Shareholders are not what they used to be. Historically, shareholders invested for the dividend stream and, accordingly, were interested in a company’s long-term prosperity. Today, however, retail investing (like dad buying stock in Ma Bell for retirement) has declined dramatically. People, even those saving for retirement, now buy mutual funds. They don’t own stock directly. In fact, more than 70 percent of shareholders are not direct investors but agents for others. Those agents are the managers of mutual, pension, and hedge funds. And because funds are chosen based on performance, fund management is incentivized to be more interested in short-term results than in the long-term vitality of their invested companies. So the modern shareholder, rather than exerting pressure for the long term, usually exerts pressure for just the opposite. This is especially true of the growing legion of corporate raiders, now called “activist investors.” These activists do not really invest. Rather, they are speculators who buy stock from others and then make demands on the company as if the company were using their money. Like the killers of the golden goose, they seek to harvest the company’s internal wealth and distribute it to themselves.
Activist shareholders are using these myths and others to persuade America that shareholder activism is good for the economy. Yet there is little to suggest that modern shareholder activism is generally beneficial either to companies or to the nation. And there are many communities, former employees, customers, and even long-term investors who would say such activism causes great harm.
Debunking these myths is important because together they are used to justify shareholder raids on corporate treasuries. Coupled with executive stock options, they pressure managers and directors—even in firms not directly targeted—to favor short-term harvesting over long-term investing.
Indeed, the growing pressure on public companies to act short-term and distribute rather than reinvest is likely one of the causes for the precipitous decline in the number of public companies—down almost 45 percent in the last 15 years. Today far more capital flows out of public corporations than flows in. Corporate profits, once a source of growth, are instead being dispensed to shareholders. In the last 10 years, the companies in the S&P 500 have distributed 91 percent of their profits to shareholders as dividends and stock buybacks. In effect, planting has been replaced by harvesting. The business press is replete with stories of companies slashing people, research, and investment. Some companies are even borrowing and going into debt to generate more cash for shareholders. Alarmingly, this net outflow to shareholders mirrors almost exactly what happened to British companies 100 years ago as Britain’s economic star began to fall.
Other sad effects of these trends are public reaction and the corporation’s place in American society. In an effort to protect themselves, companies have done things that hurt employees, communities, and even customers. As Forbes reported, public trust in America’s business leaders has plummeted so much that fewer than one in five Americans trust business leaders to tell the truth.
It is time for the American people to rethink these destructive trends. Where do we start? We must recognize that incentives work and the bad behavior we’re seeing is the result of incentives. The tax and regulatory incentives that the myths encouraged us to put in place, must be changed. Thoughtful scholars have proposed many ideas. I’ll mention four:
Reform Capital Gains Taxes. Capital in America is plentiful, so much so that bankers are creating entirely new “products” with which to extract cash from the flush “casino.” In that environment, corporations become the gambling objects, subject to similar corrupting pressures gambling puts on fighters, racehorses, or sports teams. One interesting proposal that would help fix the problem is to shift incentives from harvesting and toward building. It would revise the tax code such that short-term gambling winnings are taxed heavily and longer-term investments much less. For example, profits on traded assets held less than a year would be taxed at ordinary income rates or even higher. The profit on invested assets held longer than a year would be taxed at a lower capital gains rate, possibly decreasing the longer the asset has been held. In addition to being a boon to those saving for college or retirement, such a code would be a powerful incentive against trying to make a quick buck by gutting a company. Rather, it would encourage long-term investment and help management look to the future rather than just the next quarter.
Executive Stock Options. Concerned about runaway executive pay, in 1993, Congress capped the deductibility of executive salaries unless they were performance based. The unintended consequence was to shift executive compensation away from salary to stock options. Those options granted the right to buy stock at a fixed price and sell it later at the market price. Not surprisingly, the effect was to focus executive attention on boosting stock price as rapidly as possible. If instead the law had required that qualified options must not vest for at least, say, five years, much mischief could have been prevented. To align executive incentives with the long-term health of the enterprise, options should be required to have a long vesting horizon.
Revise SEC Rule 10b. Rule 10b-5 was enacted to prevent companies and persons from committing securities fraud by trading stock with insider information. In recent years the SEC has relaxed interpretation of the rule to permit a company to buy its own stock more aggressively. That, in turn, has enabled the phenomenal increase in the amount of repurchased stock, repurchases that often benefit shareholders and executives at the expense of the company. Because such buybacks incentivizes short-term thinking and even fraud, they should be severely restricted.
Earned voting rights. Another interesting proposal would not invest shareholder voting rights until a stock has been held for at least a year. The obvious purpose is to not allow short-term traders and speculators to have any effect on the management of the company, while still maintaining normal rights for true investors who hold the stock for the long haul. There could be another benefit. Shareholders often complain that they do not have enough say over a company’s direction. Much of the resistance to increasing shareholder power is based on fear of speculators and activists. If that fear were assuaged by EVR, increasing shareholder power might be a means of checking bad or ineffective corporate managers.
None of these ideas is new and some have been used in the past with success. Taken altogether, they shift the incentives for both management and investors toward the long term. Incentives work. We should give them a try. Our future depends on it.
This essay also appears at Democracy: A Journal of Ideas.