Predatory Value Extraction

Predatory Value Extraction: How the Looting of the Business Corporation Became the US Norm and How Sustainable Prosperity Can Be Restored (Kindle/Hardcover), by William Lazonick and Jang-Sup Shin, chronicles how agency theory and ‘maximizing shareholder value’ (MSV) led to looting of publicly traded companies. As many of us sit home waiting out the COVID-19 pandemic, it is a good time to rethink the purpose of the corporation. Corporate governance needs revamped if we are to move from a model of value extraction, which accelerates wealth inequality, to one of value creation.

Efficient markets, they argue, are the result, not the cause of a highly productive economy. “The foundation of economic development is the ‘investment triad’: household families, government agencies and business enterprises.” There are no free markets. Rules, set by citizens and our representatives, are necessary for the trust and trade necessary for a dynamic economy. This is a “must read” book for anyone asking fundamental questions about how to build a future we can all feel proud to live in. 

The critique of Lazonick and Shin is well documented, while their blueprint for restoration needs more work. However, I hope all who read will at least submit a comment to the SEC in favor of rulemaking petition File 4-746 to repeal and rewrite Rule 10b-18. Send a PDF letter by email to rule-comments@sec.gov. Include the file number of the rulemaking petition in the subject line (File 4-746). It should be addressed to: Vanessa A. Countryman, Secretary, SEC, 100 F Street, NE, Washington, DC 20549-1090. Your comment could be as simple as,

Please move favorably on repeal and reform of Rule 10b-18 to address manipulative repurchase programs that harm workers and Main Street investors. Instead of rewarding investors for holding shares, buybacks reward executives, Wall Street bankers and hedge funds with inside information for selling shares.

Rewards do not accrue to what SEC Chairman Clayton describes as Mr. and Ms. 401(k), who typically buy and hold index funds until retirement.

Predatory Value Extraction: From Retain and Reinvest to Downsize and Distribute

Between 2008 and 2017, S&P 5oo companies paid out 41% of net profits in dividends, the traditional way of rewarding shareholders. That money went to reward shareholders for keeping their stock. In contrast, those same companies repurchased $4 trillion of their stock, equal to 53% of net income. That money went to share sellers who were best positioned to time their sale to coinside with open-market repurchases. Who typically has that insider information? Senior executives, hedge-fund managers and investment bankers, answer Lazonick and Shin.

In 2018 corporations used nearly 60% of their corporate tax cut to repurchase stock. Nearly $1 trillion went to executives, boards of directors, and large share sellers. Instead firms could dedicate this capital to worker wages, training, hiring, and other investments necessary for innovation and growth. The period of accelerated stock buybacks conincides with decoupling the growth of productivity and hourly compensation.

Predatory Value Extraction: Figure 1

It may make some sense to pay out 94% of net profits in cash cow commodity industries where products are undifferented and the need for innovation has long passed. However, even in such industries, why reward share sellers, rather than share sellers, with the bulk of profits? More fundamentally, shouldn’t our largest companies be innoative enterprises where retain and reinvest strategies are warranted?

I found Lazonick and Shin’s book disturbing, especially when they attack personal heros of mine like Robert Monks and Lucian Bebchuk, as well as long-standing theories with too broad a brush. We must start from where we are today, not from some ideal world where we hope to be in the future. For example, Lazonic and Shin call on us to “reconstitute corporate boards of directors to include representatives of households as workers, as taxpayers, and as savers as well as households as founders — and exclude the predatory value extractors.” We should replace agency theory with innovation theory. Lazonick and Shin are good at showing the sytem is broken but they only hint at how we are to move to a brighter future. For example, I can imagine workers on corporate boards, maybe elected through an employee stock ownership trust that holds a significant minority stake in company equity. More difficult is imagining how taxpayers would be selected for corporate boards. 

Maybe if we briefly go through each chapter, we can better separate the wheat from the chaff.

Value Creation

Chapter 2 reviews several mistaken assumptions of neo-classical economic theory, and reminds me why I switched my major from economics to sociology more than 50 years ago. I was more interested in studying actual behavior and aspiration than mathmatical formulas based on how economist think economies would operate if actors were rational.

One fundamental flaw is that markets, through an assumed perfect competition, not firms, allocate resources in the economy. Under that neo-classical theory, monopolies maximize profits subject to the same cost structures as their competitors. If that were the case, the most unproductive firms would provide the foundation for the most efficient economies.

Lazonick and Shin posit instead that successful companies lower their cost structures by generating higher quality products and services through the collective innovation of their founders and employees. Collective learning provides the foundation for growth. Worker compensation then becomes not just a cost to be monitored but a reward system for collective learning, which is at the base of innovation. 

Governments can play a strong role in fostering collective learning and value creation. A long list in the US includes fostering railroads, telegraph/telephone, airlines, highways, internet, land grant colleges, agricultural experiment stations, integrated circuits, life sciences, etc.

Predatory Value Extraction: Stock Market as Vaule Extractor

Contrary to what many believe, the stock market is a net extractor of value from corporations. The primary function even of initial public offerings (IPOs) is not to raise capital but to enable early investors to exit at least a portion of their investment. Shareholders, investing in secondary markets, buy shares from other shareholders, betting on the rate of return. Especially today, with so much capital owned by the rich with few places to deploy it, the contraint on growth is not capital but creativity and organizational capabilities that allow companies to transform high fixed costs into low unit costs through innovation and volume.

The authors here recount the how large companies transitioned. Alfred Chandler noted that multidivisional structures enabled reallocation of corporate capabilities, primarily talent, to new lineds of business. Edith Penrose highlighted the close integration of strategy with organizational learning. Soon, debt-financed conglomerates with little knowledge of operations or corporate knowledge were simply “managing by the numbers,” which favored cost cutting over innovation. Public policy changes like doing away with fixed trading commissions and reducing capital gains taxes led to increased financialization.

Maximizing shareholder value (MSV) is rooted in the false notion (discussed above) that shareholders invest in productive assets. That error is compounded by the assumption that shareholders take the primary risk and, therefore, have an incentive to monitor. Taxpayers also take a risk, as do employees, neither of which are so easily disposed of through liquid securities. The authors discuss the National Instutes of Health (NIH), which between 1938 and 2018 invested over $1 trillion in life-sciences research. Tax revenues depend on the success of companies making use of that research. Workers invest firm specific human capital, which cannot exit at the same low cost as selling shares.

Senior executives “disgorge” cash through stock buybacks, not to reallocate resources within the firm but to increase their own stock-based pay, supported by hedge-fund activists also feeding at the trough. Reinvestment in the firm and long-term careers are disrupted, undermining innovative enterprise.

Predatory Value Extraction: Value Extracting Insiders

This chapter tells how, beginning in the 1980s, senior exectives moved their attention from value creaton to value extraction. Focusing on MSV and total shareholder return (TSR) drove the pay for performance link to those measure and the rise of stock buybacks, which 15 years after the SEC’s 1982 rule surpassed dividends. Instead of rewarding investors for holding shares, executives now rewarded them for selling shares. Those rewards did not accrue to what SEC Chairman Clayton describes as Mr. and Ms. 401(k), who typically buy and hold index funds until retirement.

No, the typical benficiaries of buybacks are corporate executives, investment bankers and hedge-funds who can time their sales to take advantage of the bumps in market value. Under Rule 10b-18 companies do not even need to disclose, after the fact, the days on which they buy back stock in the open market. During all the decades the rule has been in force, the SEC has never charged senior executives with use of insider information to profit from such repurchases. Since 1991 amendments, gain from such sales are not even subject to “short-swing profits.” They not only gain on such sales, they also gain on any “pay to performance” measure tied to MSV or TSR.

A 2005 study found that executives in non-finance businesses made up 41.3% of the top 0.1%, while finacial professionals accounted for another 17.7%. Feel left out?

Predatory Value Extraction: Value Extracting Enablers

At this chapter my thoughts begin to diverge from those of Lazonick and Shin. They open with a discussion of the “misguided” movement for shareholder democracy, which I discuss in more detail at A Nation of Small Shareholders. That movement was initially begun by the NYSE as a means of increasing broker revenues, lowering public resistance to decreases in capital gains and estate taxes, as well as bolstering capitalism against the attractions of communism.

Yes, it was misguided in the sense that early on, while individuals owned far more shares than institutions, the “movement” (PR campaign) did not emphasize the role of investors in corporate governance. Actual democracy requires an investment of time and effort, just as Benjamin Franklin supposedly warned we have “a republic, if you can keep it.”

Lazonick and Shin make too little of that possibility. For example, they criticize Robert Monks and his efforts to ensure pension funds (and eventually mutual funds) treat proxy voting rights as plan assets with accompanying fiduciary duties (Avon letter, 1988). They are critical of the 1992 SEC rule change that allowed instutions to communicate with one another about corporate governance issue without it being deemed a proxy solicitation without filing a Schedule 14A. Perhaps their greated animus is aimed at Institutional Shareholder Services (ISS), “a monster created by compulsory voting… a voting monster no one could have ever imagined.” 

Yes, “shareholder democracy” has turned out badly but it has never been provided with the adequate tools to succeed. Too many Americans have bought into the notion that economics and investing are value-free. Beneficial owners have abbrogated responsibility to financial experts, who have not been trained to facilitate shareholder democracy and often know little about how their clients proxies are voted or why. True, even well-meaning public pension funds have particpiated in looting companies for short-term gain, since staff and contractors are often paid to incentivize short-term performance. There are problems, indeed, but if shareholder democracy is to work, which I think is a good goal, being able to communicate and intelligently voting of proxies are essential.

Just to touch on one issue raised by Lazonick and Shin, “ISS tends to apply general and mechanical corporate-governance metrics to its voting recommendations.” Proxy voting for many funds is a legal obligation, not something they see as value additive. Therefore, they are unwilling to spend much for advice. In the late 20th century, Mark Latham designed a shareholder proposal to address the need for more company specific proxy research. Shareholders requested boards hold a competition for giving public advice on the voting items in the proxy with prizes large enough to incentivise more in-depth research and competition. Companies would award monetary prizes for the best advice, as determined by shareholders when voting their proxies. See Shareowner Proposal Campaign for a list of filings and links.

Another way to incentivize more concientious proxy voting would be to require funds to report their proxy votes in real-time and in user-friendly format. See SEC Rulemaking Petition File 4-748. Once beneficial owners see how their proxies are being voted, many will demand change… especially at ESG funds voting against ESG proposals. (see How Fund Families Support ESG-Related Shareholder Proposals by Jackie Cook)

Predatory Value Extraction: Value-Extracting Outsiders

Lazonick and Shin critically review hedge-fund activism and find in largely value extractive, again attacking another hero of mine, Lucian Bebchuk. They show how the 1996 National Securities Markets Improvment Act (NSMIA) dramatically increased funds available to hedge-funds by removing the limits on how many “qualified purchasers” (individual investors with $5M and institutional investors with $25M) could participate in a fund. Hedge funds increased from $118B assets under management (AUM) to $2.1T in 2007 and over $3T in 2016. 

The leading sources of funds are public and private pensions and endowments. One of every five university endowment dollars are invested in hedge funds. Over time, hedge funds have moved from corporate raiders, using greenmail and other obviously value extractive tactics, to “proponents of shareholder democracy.” Despite the new rhetoric, hedge fund manager performance is still measured on relatively short-term value extraction. Methods typically include mass layoffs, tax avoidance, price gouging, sale of corporate assets, acquisition of cash-rich companies. They are not typicall focuse on innovative strategies aimed at creating value in the future.

Again, Lazonick and Shin are spot on. Again, however, they appear weak on suggested solutions. We should at least be discussing disclosure requirements. When alumni contribute to endowments, are they aware those funds are like to contribute to deconstructing the American economy? 

In Who Bleeds When the Wolves Bite?, Leo E. Strine Jr. outlines several possible reforms, including:

• All-in disclosure of financial instruments of any kind—long or short, natural or synthetic—tied to the value of the company’s stock so market participants can understand a fund’s ability to gain from increases or decreases in a target’s stock price.
• Requirements should address what information an activist can share with potential “wolves” before the activist goes public.
• Eliminate the unfair tax advantages hedge funds get over human laborers—e.g., the ability to treat some of their managerial income as capital gains rather than wages from labor under the “2 and 20” model—would also diminish the ability of hedge fund managers to reap profits not shared with their investors and their targets’ other stockholders in the long-run. This would therefore shift the activist hedge fund market directionally toward those fund managers able to generate value by contributing managerial expertise that creates durable value for the public companies in its portfolio.

Innovative Enterprise Solves the Agency Problem

The authors posit that “innovative enterprise solves the agency problem.” Sorry, to me the agency problem is concerned with accountability, whereas an innovative enterprise might focus on performance and sustainability. I agree with their statement:

If we want stock-based executive pay to be linked to a company’s performance, we should structure it to reflect stock-price movements that result from innovation rather than movements that result from speculation or manipulation.

I agree,

There is virtually no evidence that hedge-fund activists intervene in companies to promote investments in innovative products that may, or may not, pay off in the future.

How can we get them to do so? In theory, Jeffry Ubben’s investment in BP could move the giant oil company to move investments away from oil to more renewable resources.

Lazonick and Shin draw a distinction between investors, who participate in the process of value creation, and savers, who simply seek income and appreciation from value extraction. Savers should only be paid through dividends after who contribute to value creation have been paid and capital has been retained to generate innovation.

Reversing Predatory Value Extraction

At the conclusion of their book, Lazonick and Shin boil down their most substantive recommendations to the following five:

1. Rescind and Rewrite SEC Rule 10b-18, which facilitates the use of share buybacks for predatory value extraction, primarly by company executives, Wall Street bankers and hedge funds. Read and support rulemaking petition File 4-746.
2. Redesign Executive Pay. We should get rid of US-style stock-based pay, which rewards speculation and manipulation more than innovation. Senior executives should, instead, be incentivized around metrics related to innovation. This recommendation comports well with the advice of Steven Clifford in The CEO Pay Machine: How it Trashes America and How to Stop it (see it).
3. Reconstitute Corporate Boards. Workers and taxpayers take more fundamental risks than shareholders, so would have board seats. While I agree in principle and can easily envision workers having a couple of director seats, I have a harder time imagining how that would work for taxpayers. A higher proportion of earnings in options or stock and a lower proportion of cash will allow employers to keep on more workers in bad times. Workers will always want more in wages because they would not have to share that with other shareholders. But there should be some boost in productivity from greater employee ownership and participation. How employee representatives are chosen will be crucial but can be worked out. I am not sure how that would work among taxpayers. Governments at multiple levels enable corporate infrastructure. Lazonick and Shin are of little help in sorting that out. As part of corporate governance reform, they recommend three additional changes.
   1. Abolish the obligation on institutional shareholders to vote, arguing they should not have to vote is they have not taken the effort to inform themselves on the issues. I would see that as an abbregation of fidicuary duty. There are other options. One is the type of proposal I mentioned that would increase firm-specific proxy voting research by way of contests. A second would be to facilitate mostly voting in line with like-minded funds through if then tiered system decisions, as Moxy Vote once facilitated. A third option would be to pay substantially more for better proxy research.
   2. Eliminate the power of the managers of institutional funds to exercise voting rights attached to saver’s shares. That recommendation makes little sense to me. We just need to hold those managers accountable for how they vote. That is not being done now because funds only announce their votes up to a year after the fact, when few pay attention, and they announce using a form that is unintelligible without subscribing to an expensive database service. If the SEC required transparency, we could be picking our funds not only on the basis of historic returns and cost, but also on how well proxy voting by funds aligns with our own values. See and support SEC Rulemaking Petition File 4-748.
   3. End the right of public shareholders to directly engage corporate executives. Yes, hedge-funds have often used such engagements to the detriment of other shareholders, workers and the public. However, many more engagements with shareholders involve issues such as corporate disclosure of political contributions and lobbying expenses, how they intend to address greenhouse gas emissions, what steps they are taking to diversify their board, etc. We need more transparency of hedge-fund activities. We should not throw out all the good that shareholders do to avoid the bad.
4. Reform the Corporate Tax System. Yes, we should repeal the Republican 2017 tax package that gave huge tax breaks to corporations and wealth households. Many more tax reforms are needed to get companies to pay more for government infractructures so necressary in creating an innovative economy.
5. Redeploy Corporate Profits and Productive Capabilities. The authors acknowledge that a full career with one company will not return as the norm. Employees need collective and cumulative careers over the course of thier career to avoid stagnation after decades of work. A quick hit on Wall Street or through an IPO must be made less attractive than a sustained career and stable growth in an innovative, productive economy if we are to avoid the dangers of further wealth and social inequality. Here the authors circle back to the prior recommendations.

See some on-topic slides from a presentation by Lazonick at a Tax the Rich Conference. 

Predatory Value Extraction: Conclusion

In summary, Predatory Value Extraction is an excellent book with plenty of important observations and some good recommendations. It includes many valid criticisms of important work by others but we should not be tempted to dial back increased communication and democracy because those tools have been used most effectively by short-term hedge funds. Instead, we need to focus on mobilizing the masses, increasing their education and participation in corporate governance. Once they see how their funds are voting, more will become interested in those votes. They may then begin to explore funds that announce their votes in advance of meetings. They may also begin to join with others in social networks aimed at influencing proxy votes.