Shareholders' glory days may be numbered
By John Plender
Published: January 28 2003 17:32 | Last Updated: January 28 2003 17:32
<<What I write bluntly here. This guy writes politely :-)>>
Within the Anglo-American world the structure of capital market incentives has pushed managers into manic efforts to raise the price of their stock in the short term at the expense of genuine shareholder value.
This was epitomised by Bernie Ebbers' singular approach to investor relations during the bubble, which consisted of pointing to a chart of the soaring WorldCom share price and bluntly asking: "Any questions?"
The irony here is that the shareholder value movement has ended up replicating the errors of socialist planners in the old Soviet Union who imposed targets on industrial managers that were frequently met by fiddling the figures or doing damage to some other aspect of the business.
When managers found that they could not generate enough short-term profit to satisfy investors and stock market analysts in the bubble period, they resorted to takeovers as a means of keeping one step ahead of the baying hounds of the financial community. And when takeovers became difficult to pull off in the depressed stock market conditions that followed the bubble, they took to window-dressing the figures either within the rules or outside them, as at WorldCom.
The debate about stock options gives rise to a wider question about the shareholder function and the role of equity in global capital markets. Will the Anglo-American model prove as well suited to changes in the pattern of economic activity and technological development in the decades ahead as it was to the turbulent business environment of the 1990s? There are grounds for thinking that a system that glorifies the role of the shareholder may be less well suited to the world we are moving towards.
Outside shareholders such as mutual funds and pension funds are being squeezed out of their ownership rights in the information technology sector. If the very generous grant of stock options to directors and employees of high-technology companies had been accounted for as an employment cost, it would have been apparent that in many cases most of the profits were being removed by insiders.
Microsoft provides the most obvious case in point. It issues lavish amounts of equity to its directors and employees in the form of stock options, which under current US accounting principles are not charged against profits.
Had they been charged, according to the London-based research firm of Smithers & Co, employee costs paid in the form of options at Microsoft would have come to an estimated $11bn (£6.7bn) or so in the year to end-June 2000. On that basis these employee costs would have absorbed 77 per cent of the published pre-tax profit. The comparable figure for the whole information technology sector was 73 per cent. This compared with a figure of just under 20 per cent for the survey sample of 325 of the largest US listed companies.
What emerges strikingly from the numbers is the contrast between high-tech companies in which human capital is vital and low-tech industries such as utilities, where the cost of employee stock options is minimal. On one view, the huge transfer of resources from shareholders to directors and employees in the information technology sector amounted to a colossal failure of ownership. The institutional shareholders could have used their power to prevent this misappropriation of value but chose not to do so. Yet it could more plausibly be argued that in a business where so much competitive advantage derives from human capital and there is no continuing need for outside equity, giving the shareholder the ultimate right to the profits of the business is unrealistic and unfair.
In the 19th century the directors' duties were owed exclusively to shareholders, for the good reason that risk capital was scarce, while labour was cheap and plentiful.
Even in industries where knowledge was important, intellectual capital was not, in itself, the key to success. Only those few companies capable of crystallising the knowledge in huge investment in physical assets were able to profit from it. So the notion of the shareholder as the risk-taker of the system, with a right to the residual profits after workers and other claimants had been paid, was both logical and inherently legitimate.
Today, requirements for capital and labour fluctuate. But the developed world is not short of savings. Human capital, which consists of skills acquired through education or experience at work, is more scarce than financial capital, which is now a mere commodity. This intangible capital belongs to the individual members of the workforce. Some forms of human capital may be specific to a single company, as in skills relating to software developed for a specific project. Others, such as derivatives dealing skills, are transferable.
It follows that it is increasingly difficult to measure the value of the inputs of managers and employees as against outside shareholders. The boundaries are fuzzy and property rights become indistinct. But we do know that the shareholder is not the ultimate risk-taker in this kind of world. The value of the shareholders' input, especially if the company is large and has no need of external capital, is not conspicuously great.
In this fuzzy environment it is wrong to ignore or disguise the real cost of employee stock options. But it is not clear on what basis the revenues should be shared between shareholders and employees when it is not possible to identify a specific market value for individual employees or where the employees have made investments in skills that are specific to the firm.
It is certain that the rougher corporate governance disciplines such as hostile takeovers are more likely to destroy value in such firms than to enhance it. Knowledge workers are footloose and can take value elsewhere if a new and unwelcome ownership is imposed on them. And if they live with the threat of hostile takeover, they will be more reluctant to make investments specific to their company or to share knowledge with fellow employees.
It follows that thinking about companies in terms of the old categories of capital and labour, with a layer of management to mediate between the two, no longer makes sense. An old model of capitalism having gone off the rails, the challenge now is to find a new set of rails to enable knowledge managers and workers to be incorporated into the corporate governance process.
That points more in the direction of something akin to the currently unfashionable insider, or stakeholder, systems of capitalism, in which accountability is imposed by informed insiders rather than outside shareholders working through independent non-executive directors and a hostile takeover discipline.
The trouble with this diagnosis is that measuring realistically the inputs of managers and employees against those of shareholders is simply not possible in the present state of the accountancy art. Much effort, for example, has been put into establishing methodologies for valuing brands. Yet the numbers produced by brand valuation consultants have carried little credibility in stock markets. As with other intangible assets, judgments about brand values, even when dressed up with fancy valuation models, are too subjective to be very helpful.
The likelihood is, then, that the English-speaking countries will continue to muddle along with a corporate governance model based on shareholder primacy. Yet it needs to be made more sensitive to the interests of stakeholders, on the grounds of both the importance of human capital and the imperative of addressing externalities such as the environment.
The recent US bubble can be seen as symptomatic of yet another awkward transition. Changes in the relative scarcity of human and financial capital, along with advances in financial innovation, have created tensions and instabilities in a system that was designed for a very different world. Company law, corporate governance and accountancy have been stretched to the limits by this upheaval.
In effect, the bubble has been a rite of passage. And that, in the end, is the best argument for optimism about the workings of private capital. Having lived through a period in which some of the world's most intelligent economists and financiers swallowed the gloriously simple notion that impatient capital could be a magic bullet for the world, we are now back to capitalism as usual.
It will take a long time to reassemble a capital market model that better fits the new circumstances. But, unlike the old Soviet Union or modern Japan, the US has a remarkable capacity for rapid policy responses, which is shared to a considerable degree by the other English-speaking countries. So while capitalism has not been wisely managed of late, it will be better managed in the Anglo-American world as a result of the bubble. Until, of course, the next bubble comes along.
Excerpted with permission of the publisher John Wiley & Sons. From Going off the Rails. Copyright 2003 by John Plender. Available at bookshops, online and from www.wileyeurope.com |
