The past 70 years have seen three massive, value-destroying market crashes. After each, regulators have attempted to punish wrongdoers and implement fixes to prevent future meltdowns. It hasn't helped, because regulators have focused on symptoms instead of root causes. The only way we can avoid increasingly frequent stock market meltdowns -- and all the pain, suffering and economic dislocation they cause -- is to explore the theories that underpin American capitalism. One theory in particular deserves our close attention, due its pervasiveness and power -- shareholder value theory.
In 1976, finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester published a seemingly innocuous paper in the Journal of Financial Economics entitled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." It would go on to be the single most frequently cited article in business academia and forms the prevailing theory of the role of the firm and proper compensation in our society today.
The article first defined the principal-agent problem and created agency theory. In the authors' construct, shareholders are the principals of the firm -- i.e., they own it and benefit from its prosperity. Executives are agents who are hired by the principals to work on their behalf. The principal-agent problem occurs because the agents have an inherent incentive to optimize activities and resources for themselves rather than for their principals. For example, an executive might declare her own time to be so valuable that she requires a private jet to ferry her around. While this might be convenient for the executive, and may even increase her productivity level, it may well hurt the owners of the company, reducing earnings by more than the increase in productivity. Such a choice puts an agent's interests ahead of those of the principals and creates an agency cost.
Jensen and Meckling argued that when executives squander firm resources to feather their own nests, the result is both bad for shareholders and wasteful for the economy. Instead, the theory goes, the singular goal of a company should be to maximize the return to shareholders. To achieve that goal, the company must give executives a compelling reason to place shareholder value maximization ahead of their own nest-feathering. While it is not possible to entirely eliminate the self-interest of executives, the authors posited that we could better align that self-interest with the interests of shareholders; we could eliminate agency costs by giving agents meaningful amounts of stock-based compensation, actually making them shareholders as well as executives. Executives would then be very interested in increasing shareholder value, because when it increased, so would their own compensation.
Like all good theories, agency theory had limitations and unexpected side effects, a fact its disciples have chosen to ignore (though Jensen himself has acknowledged them). In particular, the theory had the unfortunate effect of tightly tying together two markets: the real market and the expectations market.
The real market is the world in which factories are built, products are designed and produced, real products and services are bought and sold, revenues are earned, expenses are paid and real dollars of profit show up on the bottom line. That is the world that executives control -- at least to some extent.
The expectations market is the world in which shares in companies are traded between investors -- in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to expectations of future performance shapes the stock price of the company.
Historically, professional managers played entirely within a single market: they were in charge of performance in the real market and were paid for performance in that real market. That is, they were in charge of earning real profits for their company and they were typically paid a base salary and bonus for meeting real market performance targets.
Compensation rooted in the expectations market used to be rare. In 1970, for example, stock-based incentives accounted for less than 1 percent of CEO remuneration. But that all changed after the advent of agency theory. Implicitly, Jensen and Meckling had argued that the way to spur executives to best perform their duties in the real market was to make their pay significantly dependent on the performance of the company in the expectations market. This was a critical shift. After 1976, executive compensation became increasingly stock based, so that when executives produced a stock price increase in the expectations market, their compensation rose dramatically. In 2009, for instance, the highest-paid CEO in American was Larry Ellison of Oracle, and estimates suggest that 97 percent of his paycheck came from realized gains on options. Ray Irani, CEO of Occidental Petroleum, earned $31 million in 2009, including $1.17 million in base salary, a bonus of $1.2 million and restricted stock awards of just under $25 million. It has become an accepted premise of good governance that, in order to properly align their incentives with those of the shareholders, executives and board members must receive a substantial portion of their pay in the form of stock-based compensation. The market crashes of 2000-2002 and 2008-2009 did nothing to diminish this premise; in fact, they strengthened it.
Few people conceive of the world of business in terms of real and expectations markets. Yet, there is another world in which the distinction between a real market and an expectations market is much more profoundly understood -- the National Football League (NFL). While it isn't a perfect metaphor for business, it is a highly instructive one. It is one we will pursue tomorrow.
This post is excerpted from Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL, to be published May 3 by the Harvard Business Press. Read more from Fixing the Game here.
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I think the root problem lies in the widespread article of faith that we must accommodate greed. The solution to the problem of agency has long been solved by something called "fiduciary duty." It means precisely that you cannot put your interests ahead of your client or employer's.
Fiduciary duty is not something exotic or new. We specifically impose it by law in the case of lawyers and real estate agents, for example, but it's something we expect in our ordinary business transactions. When your dentist does the $900 space-age repair and doesn't tell you about the $150 equivalent, when the auto mechanic tells you you need the expensive oil but you don't, these are violations of fiduciary duty, and we instinctively understand there is dishonesty behind them.
We should impose a fiduciary duty on executives of publicly traded businesses because pandering to their greed has not so far resulted in the desired behavior from them.
John
repeatedly stripped of their wealth and dignity.
Fourth problem - virtually no where else, for most income levels, to invest their money for growth with real estate on the skids and collectables beyond reach price wise.
So, what's a guy seeking wealth to do?
Here is my free advice (you did not ask - but there are so many in need, I'm giving it anyway).
First, unless you can marry-up with the 2% winners somehow (later), end your long-term game of trading stocks. If you do trade with the 2%, you will find that you won't be in any trade for more than a few minutes, not years, months, days, or hours.
Trading old-school can be tranquilizing on the run up but, as happens eventually every few years, dreadful and wealth stripping on the way down.
Second, park your money in anything but financial instruments, or you will get killed again.
John
http://www.DayTradersWin.com
(More - below)
So, what's a guy seeking wealth to do?
Here is my free advice (you did not ask - but there are so many in need, I'm giving it anyway).
First, unless you can marry-up with the 2% winners somehow (later), end your long-term game of trading stocks. If you do trade with the 2%, you will find that you won't be in any trade for more than a few minutes, not years, months, days, or hours.
Trading old-school can be tranquilizing on the run up but, as happens eventually every few years, dreadful and wealth stripping on the way down.
Second, park your money in anything but financial instruments, or you will get killed again.
Third, if you must trade, trade with and compete with the 2% winners:
1. Day Trading new-school in control of you money and your emotions with the following,
2. New day trading system - new perspective of making money in minutes, new tactics for executing trades,
3. Learn the new game with a master day trade, day trader, day trading COACH, just like world-class athletes, CEOs, and politicians do with their coach,
4. Trade a COACH and other winners - never trade on your own.
That's my response to your article, Roger Martin. I hope it helps you and others.
John
http://www.DayTradersWin.com
So what's the real problem here with "value-destroying market crashes"?
I think - 3 problems:
1. Investors, swing trader, day traders, and all those entrusted with retirement funds, are either incompetent or get tricked when dealing with unexpected market index and stock price movements, particularly price movements to the down side. When the markets take a hit, like during 2000 Tech Bubble or the 2009 Mortgage Crises, traders are incapable of exiting, or just refuse to sell - holding and suffering to the bottom - over and over again, as the markets and stock prices cycle.
2. Based on my observations, 98% of all traders, sooner or later, get killed by the 2% software sophisticated winners. Since the tech bubble, the game has dramatically changed - winning strategies, tactics, rules for trade execution have all changed to the distinct advantage of those 2% who changed the rules in the first place and the distinct disadvantage to 98%, who are the innocent victims or simply refuse to change their game.
John
3. Stock holders (direct and indirect owners of stocks and other financial instruments for gain - hedge against inflation, expecting to have returns to gain wealth, workers saving for retirement, and so on) with long term perspectives, arrogance (knowing) and their obsolete expectations are, as your article reports, repeatedly stripped of their wealth
if an executive squanders resources on a jet would that not show up as an expense that decrease earnings?
my answer is it is a lot easier to support a greedy lifestyle with unearned money from share valuations in the "expectations market" than earned money from the "real market".
Nothing would be worse than to maintain the status quo, if by “best interest” we mean: best for our personal individual development as human beings and best for those who will live beyond our time. To perpetuate current reality is to cast humankind aside for the allure of transitory material gain—for the sake of a few bucks. To be responsible beings, we must no longer put material worth ahead of human value. Societal wealth is only a small part of our well-being.
http://www.forprogressnotgrowth.com/econome
http://www.forprogressnotgrowth.com/2010/01/22/profit-isn’t-enough-for-progress/
These executives usually cash in their stocks at the inflated prices and then exit their companies to let others watch the stock prices fall when the limits of the asset loss becomes noticeable and operating maintenance costs increase due to deferred maintenance.
These executives will also inflate the book value of real estate assets, goodwill, and other intangibles to offset the increase in liabilities such as proceeds from loans on assets that are then dispensed as dividends.
This practice should be outlawed and the incentives for executive performance should be based upon increases in the net worth of the company, not the amount of hype, lies, forgeries, and public relations that inflated the company stock price.
A mix of long term comp being comprised of market price and actual earnings is what we use. Impossible to get it perfect but easy to get it close, a singular focus on one or the other is unbalanced, distorts planning and execution.
There will always be, regardless of the regulatory structures in place, folks who know how to game the system to their advantage. And, this will always create hazards for the general economy, as they who game the system try their best to make everyone else eat their losses.
As always, as a consumer, try to get educated about the risks and proceed with caution in investing.
My modest proposal: eliminate corporate income taxes. (Stay with me). In exchange public companies must become pass-throughs, distributing retained earnings to their shareholders (100% tax on retained earnings). Limit executive pay 100 x average workers. Sixty percent surtax on executive bonuses over one million whether paid in options or cash (marked to the market). No tax preference for cap gains or dividends.
In short, corporate profits not reinvested in jobs, plant and equipment go to shareholders and are taxed at ordinary rates (unless in tax deferred accounts). No incentive to offshore jobs or profits. No tax gimmicks. No taxes if they play by the rules. Instead they will make better investments in long term growth of our economy. In addition I would replace the payroll tax with income taxes--but that's for another post.
2) What happens in economic downturns? ALL profits either paid to shareholders, gone or given to feds, gone. Borrow? See #1.
I would also argue that it is not in the public's interest for "singular goal of a company should be to maximize the return to shareholders". There are other purposes and responsibilities of a business or corporation, in the real world. They should also maximize return to their hard working employees and to their local communities. They should maximize return on pollution, and share in their responsibilities to maintain and respect mother earth.
There is far too much interest for shareholders, leaving our economy in a dangerous imbalance in favor of the few. The entire business model must be changed accordingly, by regulation and force if necessary.