Corporations Don’t Represent Our Ultimate Interest As Their Owners, Their Employees and Customers.

This is part one of a two-part review of Accountable: How We Can Save Capitalism by Michael O’Leary & Warren Valdmanis (Penguin Business 2020), is a very interesting read. Both authors have impact investing backgrounds. Valdmanis invested with Bain Capital’s private equity team before becoming Managing Director of Bain Capital’s social impact fund, and O’Leary was on the founding team of that fund. Valdmanis now leads a social impact fund that invests in the American workforce. O’Leary is an economic policy advisor in the United States senate.

It is their investment background, and the investment focus of most of the people they refer to and cite throughout the book, that makes the book so interesting. As they note, it allows them to “debunk the myths of capitalist reform from the inside”. They state “We’ve lived in the engine room, investing billions of dollars, and working across six continents and dozens of industries. We’ve earned our MBAs from schools where the virtues of capitalism are recited chapter and verse.”

O’Leary and Valdmanis argue “the United States has always struggled with the morality of its economy” built off tabaco, slaves, fossil fuels and global finance.”

They also cite former president Rutherford B. Hayes saying “this is a government of the people, by the people, and for the people no longer. It is a government by the corporations, of the corporations, and for the corporations.”

The book is a critique of capitalism, of finance and of government. But above all it is a critique of corporations. They note, “we don’t need to change every one of America’s 6 million companies. But we do need to change the Fortune500.”

Why the reason for this focus? Because “these companies represent two-thirds of US GDP” so, “if we are going to change the course of our economy, it is these very corporations that we must change. In the fight to save capitalism, this will be the battlefield.”

Personally, I think this conclusion is wrong. First the problems will not be solved on a single battlefield, they are systemic and involve a wide variety of players, as the Kay Review made clear following the global banking crisis of 2007/8 and the Great Recession that followed.

It does makes a change for the focus to be switched from the economists and business schools to the corporations, although these others do get the finger pointed at them in the book too. But I believe in the principle of “follow the money” and, O’Leary and Valdmanis offer plenty of justification for doing so, a point I will make more clearly in my conclusion.

Within the system the many players have a role, none are without blame, but in searching for solutions I sore more important than others, and none more so than finance. This is because of the concentration of power. That is my main argument with their conclusion.

The authors list the now familiar catalogue of reasons “capitalism is once again on trial” — Inequality at a post war high, stagnant wages and the several other reasons Americans have lost their faith in capitalism. They note, two-thirds of parents expect their children to be worse off than them, 56% of people worldwide believe capitalism does more harm than good, only half of Americans under 40 view capitalism favourably, and 40% of Americans would prefer to live in a socialist country, according to a variety of surveys and research projects.

As I have said, they lay the blame at the door of the corporation arguing, “Our most critical social and environmental challenges have been caused, in large part, by the explicit amorality of corporations”, corporations that “reflect no deeper purpose than profit. They embody no broader values than shareholder value. They are accountable to nothing but the bottom line.”

They argue, not only society should want to fix the problems. “Capitalists should want to fix corporations”, to address the “lack of purpose, values, and accountability within our corporations”. They suggest we “need to ask more of capitalism”

In the view of the two authors, “corporations are capable of achieving so much more than they do today. Many are failing their employees, customers, communities, and other stakeholders. They are even failing their shareholders — who are better served when corporations are focused on creating long-term value.”

On this last point the authors are adamant “most shareholders would benefit far more if all corporations were transformed into long-term, stakeholder-oriented companies driven by a deeper purpose.”

The book is illustrated throughout with good and bad examples of capitalism based on the two conflicting versions of capitalism — the shareholder v stakeholder primacy arguments dividing the two in what I have previously described as a false dichotomy in The Primacy Debate and False Dichotomies.

They suggest the Kraft Heinz attempted takeover of Unilever in 2017 illustrates the two competing models. Back in 2017, when the hostile takeover attempt was made, I wrote an article — Are Business and Capitalism Facing Their Marmite Moment. It described the episode as a great way to contrast the two views of capitalism, and it is interesting to see how badly this played out for Kraft Heinz, tarnishing the legacy of Warren Buffett in the process.

The shareholder primacy argument, the doctrine of Milton Friedman, is the driver of the approach taken by 3G Capital backed Kraft Heinz, with the support of Buffet. The stakeholder focused approach is illustrated by Paul Polman’s perspective. He is the former CEO of Unilever and was CEO at the time of the hostile takeover attempt.

O’Leary and Valdmanis note, “3G’s intentions with Unilever were based on two numbers: 23 and 15. The difference between them could be worth billions of dollars.” The figures represent the difference in the profit margins between Kraft Heinz (23%) and Unilever (15%) at that time. 3G were betting the difference was down to inefficiency at Unilever.

Had it been successful 3G would have applied its usual strategy of ripping out costs, in large part resulting in mass redundancies. In the process it would have destroyed the engine for future value creation, as it did at Kraft Heinz. If you are in doubt about that look at the results of both companies since.

In the two years following the failed bid Unilever’s share price grew 40% to nearly $60, well above the $50 offer that was made, and 3G lost 61% of its value falling from $70 to $27. Its CEO stepped down and the SEC was investigating its accounting practices. Recent reports suggest problems are now even worse at Kraft Heinz.

The authors refer to Buffet’s involvement and note. “more than anything buffet admires sustained growth and productivity.” Any employee redundancies, which Buffet calls “road-kill”, would be regarded as a problem for government to deal with, and that really means the taxpayer.

They suggest, in saying he will donate 99% of his wealth to charity Buffett adopts the Carnegie approach: “first make as much money as possible by any means possible. Second give it away to the betterment of mankind.” They also cite Theodore Roosevelt’s disapproval — “If Andrew Carnegie had employed his fortune and his time in doing justice to steelworkers who gave him his fortune, he would have accomplished a thousand times what he has accomplished”.

The authors suggest the problem is that the 2% of GDP Americans donate to charity each year is “rendered impotent without the other 98% of GDP pushing in the same direction.

To this I would add the means of getting rich are not always justified by the ends. Or as Aldus Huxley said, good ends cannot be achieved by bad means. It is interesting to note that Howard W. Buffet, Warren Buffet’s Grandson, and a professor at Colombia University agrees.

O’Leary and Valdmanis refer to “The Two-Buffet Paradox” as the situation that asks business leaders to simultaneously lead according to the conflicting worldviews of both Buffets. To do well by shareholders and do good for society at the same time. For many corporations, the solution is “to say different things to different audiences and then continue to serve the priorities of shareholders above all” because, “it’s easier to fake good works than good returns.” And, they argue, “the fight to save capitalism exists in this tension between capitalism and cynicism.”

A message throughout the book is this, “for most corporations today, a rich web of duties, values and mutual obligations has been reduced to a single goal: maximising share price.” And this they call “fiduciary absolutism” — “a myopic focus on short-term profit above all else”.

This is the result of the Michael C. Jensen and William H. Meckling’s theory of the principal-agent problem which argued corporate managers (the agents) were not working on the best interests of shareholders (the principals). The solution, a single valued objective function of managers, became maximising financial value for shareholders.

Their theory built on the existing law of fiduciary duty and “fiduciary duty became fiduciary absolutism, and a constraint became a demand”.

The question then became which shareholders to serve, because not all shareholders have the same interests. Another solution was needed. It came in the form of the efficient market hypothesis which suggests share price is the proxy to use so, maximising share price should be the focus.

This has led to many perverse outcomes such as delayed investments, misrepresentation of earnings and expectations management. The authors describe it as “a concept that is intellectually dead but exercises broad influence nonetheless.”

O’Leary and Valdmanis also note, as a result of fiduciary absolutism “we have an economy that maximises the one thing we shouldn’t care about — short-term stock price — at the expense of everything we should.” At the same time, putting profit above all else often subverts whatever purpose corporations could be serving and should be serving.

They ask the reader, “What if the economic value a corporation created was once again aligned with the social and environmental value it created?” And this is what they advocate.

They warn, “Fiduciary absolutism doesn’t maximise profit; it maximises the profit motive. And it doesn’t maximise shareholder value; it maximises today’s share price.”

They go on and add it “often reduces meaningful employment to crass commercialism.” It “tells everyone — explicitly- that they are just cog’s in someone else’s machine , that they are line items on an income statement to be minimised.” This, they suggest, “misunderstands and underestimates human motivation.”

In one of the most important quotes from the book the authors remind us, “corporations are social organisations originally designed to solve problems, not create them. They are capable of meeting the needs and reflecting the values of their societies while making money at the same time”. In this view the purpose of the corporation is generating prosperity for all stakeholders, including shareholders.

Importantly, O’Leary and Valdmanis remind us “all but the most short-term-oriented shareholders are ill-served by fiduciary absolutism”. That is because the typical shareholder has a diversified set of stocks in a retirement account worth $65,000 and will not withdraw that money for decades. They are “best served by stakeholder-oriented corporations focused on long-term prosperity rather than short-term stock movements.”

Unfortunately, the typical owner is far removed by intermediaries from those who control corporations, and distant ownership creates more room for amoral ownership, divorced from the consequences of decisions made. The same is not true of local businesses and may explain why “75% of the general public trusts shopkeepers but only 25% trust corporate executives.”

The distance problem stems from the 1970s and the transition to institutional ownership of corporations — their focus on fiduciary absolutism and short-term profits. “Whereas institutions such as mutual funds controlled only 6% of equity in 1950, they controlled over 63% by 2016”, and their interests are “far more short-term focused than those of the workers whose retirements they manage.”

“Of the thousand largest corporations, institutions control over 73%,” and “of all shareholder votes in the S&P500 93% are cast by institutions.” They are pension funds and investment companies.

Just 3 institutional investors — Blackrock, Vanguard, and State Street –are the largest shareholders in almost 90% of the largest US corporations. Additionally, two-thirds of all capital behind hedge-funds comes from institutional investors. Most pensioners have no knowledge of these facts, or any idea what institutional investors are doing with their money, supposedly on their behalf.

Pension owners are also unlikely to be aware that because of the large number of investments the institutional investors ‘manage’, they rely on proxy advisors, firms whose only purpose is telling the investors how to vote. And two firms, ISS and Glass Stewart, control 97% of this market. The ‘managers’ are therefore outsourcing management in effect.

Institutional investors, as absentee owners, enable fiduciary absolutism to dominate unchecked. This is the conclusion of O’Leary and Valdmanis. They say “the only single tenuous connection” between institutional investors and corporations is short-term profit.

We have, the authors argue, “a financial system in which the buck stops nowhere”. So, they conclude, perhaps it is time to “reconsider who companies’ ultimate owners really are.”

Returning to the typical shareholder profile, they note he, or she, s 51years old, and 90% of their savings are in tax-deferred accounts that cannot be touch without tax penalties for about a decade. They can also expect to live for around 30 years. So, they are investing for the long-term.

Additionally, “for most shareholders, 70% or more of their income comes from their current job.” As a result, “typical shareholders care more about our economy’s ability to provide good, high-paying jobs than its ability to provide high quarterly stock returns”.

The authors go on to say, “if our corporations serve shareholders, these are the shareholders they should serve.” In addition to caring about good well-paid jobs they are neighbours of companies and live in environments that businesses pollute, and they are pick up the bill when corporations practice tax avoidance.” This list could be extended greatly. As Stanford University Professor Jeffrey Pfeffer has reported in Dying for a Paycheck, they are the victims of the workplace as the 5th biggest killer in America, for example.

O’Leary and Valdmanis remind us, almost all of us are both shareholders and stakeholders, and if corporations were run for the long-term, oriented around stakeholders, and driven by a sense of purpose, we would all, shareholders included, be better off.

But “the capitalist landscape of the United States today is populated by corporations that don’t represent our ultimate interest as their owners, their employees and customers.”

This is a good point at which to add a few comments and conclude the first part of my review of the book. In the second part I will focus on the suggested solutions offered in the book.

The focus of the book is America, which is a pity as the problem is not only American, and it may lead readers to conclude the problem does not impact on them. That would be a huge mistake. For a start, the three huge institutional investors referred to, Blackrock, Vanguard and State Street are global player. But, let me really emphasise how global this issue is with reference to the Willis Towers Watson survey of the Asset Owner 100 (AO100).

In November 2019, the survey found assets under management of the world’s 100 largest asset owners totalled US$19 trillion (35% of all global asset owner capital). “Of these, there are a number of self-declared universal owners that own a slice of the whole world economy. Additionally, “the top 20 funds total US$10.55 trillion and represent 55.5% of AO100 assets”.

As I stated above, the authors argue that in the fight to save capitalism corporations will be the battlefield. They mention other players within the system to be considered to (governments, regulators, business schools, economists, and others), but they seem to overlook how complex and systemic in nature the problems are, meaning any solutions must be multi-pronged.

The sheer concentration of power in the hands of so few players in this complex system is going to present massive challenges: 2 proxy advisors, 3 massive institutional investors, 100 Asset Owner, and 500 corporation — and all with massive influence through lobbying those supposed to be regulating and safeguarding the system.

‘Too big to fail’, they are also too big to be permitted to keep the level of power they have, especially given the fact they are far too unaccountable.

It seems to me, we have a limited window of opportunity to save capitalism and doing so will require radically reform to evolve it. So, for this very reason, the authors are correct to say capitalists should welcome reforms.

In part two of the review I will relay the reform recommendations offered in the book and demonstrate how several are closely related to the ideas I have been developing: Valueism and Social Contract Accounting. Those ideas were briefly introduced in a previous article for the London School of Economics (LSE), and have been referred to in my other articles in the Enlightened Enterprise publication on Medium. You can also visit the Enlightened Enterprise Website.

Part Two will be published on Thursday 1st October.