Inversions Are Revealing the Ugly Face of Shareholder Value

09/09/2014 03:05 pm ET Updated Nov 09, 2014

Something strange is happening to familiar American companies: Burger King has become Canadian, Pfizer seems to be trying to be British, and Walgreens has backed away from becoming Swiss only because of the outcry over their plan for a new nationality. Seeing what our companies are willing to do to escape paying income tax, people are beginning to wonder about how American our American companies are.

And when, in addition, these corporate actions are praised, and are described as what American companies should do, or even must do, people begin to wonder if something is seriously wrong--and they are right to wonder.

Inversions may or may not be important in themselves, but understanding the forces that drive corporate inversions reveals a surprising amount about the cause of two major problems; the problem of extreme income inequality and the problem of stagnating wages in America.

The driving force behind inversions was described very clearly by George Will in a recent Washington Post column. Writing a defense of inversions, George Will stated, "A publicly held corporation's responsibility is to its shareholders; its fiduciary duty is to maximize the value of their holdings."

From this statement it follows immediately that it is a corporation's "fiduciary duty" to do inversions, or for that matter, anything else, if it will lift share price.

But George Will's statement, although it is widely believed, is not accurate. There is no legal obligation, no "fiduciary duty" requiring corporations to focus on maximizing shareholder value. The reality is quite different; the reality is that shareholders and their managements have freely chosen this corporate direction. And, as we will see below, there is considerable evidence that this direction has been devastating for the country.

This focus on shareholder value is relatively new. As late as 1981 the Business Roundtable, an extremely influential organizations of major corporate CEO's, listed six constituencies they needed to consider in making their corporate decisions. The six constituencies were: customers, employees, communities, society at large, suppliers and shareholders. About these constituencies they wrote:

"Carefully weighing the impacts of decisions and balancing different constituent interests - in the context of both near term and long-term effects - must be an integral part of the corporation's decision-making and management process."

But over the course of the 1980s, our corporations changed direction in a major way. Today both the Business Roundtable and most corporations would accept George Will's statement as an obvious truth.

Given this current and widely accepted focus on shareholder value, it is both reasonable and illuminating to ask who actually benefits from that focus. Who are the shareholders? Who benefits when the stock price goes up?

Certainly corporate leaders themselves are among the beneficiaries as they are now compensated mainly by massive stock options. But although very visible, and very highly compensated, they are still a small group. Where does most of the benefit of increased stock price go? Who owns the stock in American companies?

While it is true and often stated that a good percentage of Americans have some stake in the stock market, most Americans have very little. Here is the actual pattern of stock ownership:

Roughly 1/3 of the stock market is owned by the richest one percent of Americans; 2/3, by the top five percent; and the remaining 1/3 is spread thinly across the remaining 95 percent of Americans.

Given this concentration of share ownership, the goal of maximizing shareholder value means that that our great corporations are currently dedicated to making the rich richer. And that is in fact what is happening.

Since 1980, despite ups and downs, the country has grown at a reasonable pace. However, almost all of that growth has gone to the top one percent. This is entirely different from the three decades that preceded 1980. During that period the country also grew steadily, but the rich and the rest grew together.

This changed outcome has shown itself in two ways. The first and most visible is that CEO pay went up by a factor of about 10. The second, but far more important outcome is that wages have stood still.

There is a close connection between these two results. Holding down wages is enormously valuable to shareholders. It is a gain in profitability that far outweighs the cost of the increased compensation to top management. Today, with their grants of stock options, shareholders have motivated top management to hold down wages, and management, aided by globalization and the threat or the reality of offshoring, has succeeded in doing just that. Top management's very visible increase in compensation reflects their alignment with the shareholders in gaining from the resulting increase in profitability and share price.

This outcome has now become a system problem. Today's corporate leadership is not only motivated by stock options to put shareholders first, they also know that if they do not they will not survive. It is the shareholders who elect the directors and ultimately control the corporation's direction. Today's remote shareholders, and the hedge funds and other financial firms that usually represent them, have no interest in a corporation other than in its profits and its stock price.

Our corporations do not have to be run this way. They were not run this way in the past and even today there are many examples of companies both here and abroad that are run differently and run successfully.

But above all let us not make the easy mistake of simply attacking inversions. Inversions are only the highly visible sign of something much bigger. The real issue is not about inversions; it is about the goals of American corporations, and the fact that their present goals are destructive for America.