The following extensive comments were submitted by William Lazonick, president of the Academic-Industry Research Network and UMass professor of economics emeritus, in response to my review of Predatory Value Extraction. This is dialogue a reviewer can only dream of, especially after already recieving a response from co-auther Jang-Sup Shin. More such exchanges with Shin, Lazonick, and others interested in the topics of their book — and possible collaboration — could help realize the changes needed to move from corporate models focused on predatory value extraction to more innovative value added models leading to more widespread sustainable prosperity. Comments on Lazonick and Shin’s The Rhetoric and Reality of Shareholder Democracy from other readers are invited in the box below.
Lazonick Comments on McRitchie’s Review
Thank you for writing this review of my book with Jang-Sup Shin.
I want to use this opportunity to clarify my views on how publicly listed business corporations allocate their profits, and how they should be governed to contribute to stable and equitable economic growth.
My point of view starts with a fundamental question: Where do corporate profits come from? To answer this question, one needs what I call the theory of innovative enterprise.
Profits require that people with different functional capabilities and hierarchical responsibilities go to work on a regular and sustained basis to develop, collectively and cumulatively, a product (good or service) that buyers need or want to buy. This collectivity is defined as a business firm if, in order to survive, this group of people needs to generate at least enough revenue from the sale of the product that they develop to cover the cost of producing the revenue over a sustained period of time.
The purpose of the business firm is to generate a higher-quality, lower-cost product than was previously available. That is the definition of an innovative enterprise. When a firm is successful in achieving this purpose, profits are typically an outcome. But profits are merely a cash flow, defined by an accounting period. The questions are then a) what determines the flow of profits over time, and b) how the firm should allocate its profits over time to achieve its purpose of generating innovative products on a sustained basis.
Via markets in the product that the firm is producing and selling, potential purchasers have a choice of whether or not to buy a particular product. That means that the quality of the product is paramount in generating revenue that can secure a profit. If the product is a commodity that any firm can produce and sell—i.e., if product quality is not a differentiator—then an innovative enterprise will require a superior process technology to produce that commodity at a lower unit cost. But the analysis, as summarized below, is the same because, to do either product innovation or process innovation, the firm must engage in organizational learning. If there is neither product nor process innovation, the firm may attempt to create a profit by squeezing labor costs: e.g., paying employees lower wages than the norm or working them harder and longer for the same wages. These are the types of employment relations that characterize a sweatshop.
It takes collective and cumulative learning to generate a higher-quality product, which adds to the firm’s fixed cost (even though learning is not recorded as an asset on the balance sheet because people cannot be owned). The learning must be collective because what is needed is to integrate the skills and efforts of large numbers of people in the firm’s hierarchical and functional division of labor into organizational learning processes. The learning must be cumulative because what the collectivity learned yesterday determines what the collectivity can learn today and tomorrow. Not only does the organizational learning add to the firm’s fixed cost, placing it at a cost disadvantage vis-à-vis its less innovative rivals, but the outcome of this innovative strategy is inherently uncertain. The innovating firm may fail to generate a higher-quality product, or an innovating rival may do it better.
But if the innovating firm is able to develop a higher-quality product for sale on the product market, it can, by virtue of the higher quality, attain a larger extent of that market, and its concomitant increase in sold output transforms the high fixed cost of developing its higher-quality product into low unit cost—an outcome known as “economies of scale.”
Profits that can be sustained over time come from this development and utilization of the firm’s productive capabilities, and I call a firm that can generate a higher-quality, lower-cost product than previously available an “innovative enterprise.” Depending on how these productivity gains, monetized as profits, are shared among the firm’s stakeholders—which in turn depends upon in whose interests the firm is governed—innovative success makes it possible for the firm to reward employees for their contributions to profits, even while lowering prices to buyers, paying more tax revenues to governments, and distributing more dividends to shareholders.
Indeed, the innovative enterprise tends to be highly profitable because it pays its employees higher wages/benefits and provides them with more stable employment than non-innovative competitors. These improvements in employees’ living standards not only reward them for past contributions to value creation but also serve, prospectively, as incentives for them to continue to apply their skills and efforts to present and future value creation.
Employees’ access to these rewards and the effective operation of these incentives assumes their continued employment with the firm. That is why employees need a “seat at the table”: to ensure an equitable sharing of the firm’s productivity gains, which show up monetarily as profits. With board representation and insider knowledge, employees can assess managerial claims that the company can compete only by cutting wages/benefits, laying off employees, or offshoring work. It is often the case that such actions are not warranted—particularly when the stated purpose of the firm is to “maximize shareholder value” (MSV).
The firm has other stakeholders as well because the households that populate our economy wear different hats as workers, taxpayers, savers, and consumers, not to mention inhabitants of the planet on which the firm operates. Hence, depending on the characteristics of a particular industry, there may be a variety of stakeholders who can lay claim to “seats at the table.” For example, as taxpayers, through a variety of government agencies, households supply the firm with free or subsidized access to critical knowledge and infrastructure that serve as inputs to the firm’s value-creation processes. The repayment for these taxpayer-financed inputs should be covered through corporate taxes, and households-as-taxpayers may need representation on corporate boards to ensure that their contributions to value creation are managed productively and that a proper allocation of consequent profits occurs.
Business executives, however, tend to disregard government investments in knowledge and infrastructure that enable the firms that they manage to innovate and, thereby, to generate profits. They are also apt to take for granted the various subsidies that flow from local, state, and federal coffers into their corporate treasuries. Whether they commit these omissions out of ignorance or opportunism, business executives’ obfuscation of how their firms routinely benefit from government spending permits them to assert that lower taxes are necessary if their firms are to compete. Representatives of households-as-taxpayers who fund these government investments and subsidies need a “seat at the table” so that they can assess corporate arguments for tax reductions and ensure that other board members recognize the role of government as a source of corporate profits.
Your review of Predatory Value Extraction recognizes these roles of the firm’s employees and government agencies in the value-creation process but passes over them quickly, without drawing the larger implications for corporate governance. The same is the case for the section on the stock market as a value-extracting institution. We indeed argue that, because of shares taken off the market by buybacks and M&A deals (an area that needs more attention as a possible source of predatory value extraction than is provided in our book), the stock market is a net extractor of value from companies.
But our argument delves much deeper into the functions of the stock market: Even when companies have gone to the stock market to do an IPO, the main purpose has not been to raise funds for the corporation. Rather the main purpose has been to enable private-equity investors to exit their investments, which they can do because the stock market is liquid. If, as happened in the dot.com boom or, more recently, with firms like Uber, a company does an IPO without having made any profits—and sometimes even without having a product to sell, as happens routinely in biotech—the only reason a firm can raise money on the stock market is that the market’s liquidity permits “investors” to flip their shares. (There were virtually no biotech IPOs in 2008 and 2009 because this highly speculative market had lost its liquidity.)
Even during the rise of the NYSE to the point at which it became highly liquid with the emergence of its “blue chip” stocks in the 1920s, the main function of the stock market was to separate ownership from control, leaving in place to run publicly listed corporations salaried managers who had deep knowledge of the firm’s organization and technologies. An NYSE listing’s purpose was not, as mythology would have it, to raise investment funds for companies. The Big Board stipulated a track record of profitability as a listing requirement, and therefore a newly listed company already had the accumulated retained earnings to provide the financial foundation for investment in its productive capabilities. With the assistance of Wall Street, these corporate retentions could, if required, be leveraged with long-term bond issues, at prime rates.
For their part, public shareholders have always tended to be passive precisely because the stock market’s liquidity has enabled them to exit their shareholdings at any time they chose. The centrality of retentions for corporate investment in productive capabilities, as well as the ease with which public shareholders can quit the firm, remain fundamental characteristics of U.S. business corporations today. That ease of exit is not available to employees and households-as-taxpayers precisely because they have invested in productive capabilities embodied in products and processes controlled by the firm.
So why are public shareholders the only ones who in the United States have “seats at the table”? In part it is because of the ideology that a public corporation is private property, which assumes that shareholders actually own the firm and not just shares bought and sold on the market, and in part because senior executives’ adherence to this ideology of ownership has served to secure their control over the allocation of the firm’s resources and to reward them handsomely through stock-based pay.
You write: “We must start from where we are today, not from some ideal world where we hope to be in the future.” For me, today’s reality is that we want business corporations to move back to a retain-and-reinvest allocation regime—a regime that created the vast riches that the predatory value extractors (PVEs) have been looting for the past four decades. How is predatory value extraction not our reality? We need to debunk MSV, ban stock buybacks, and place representatives of actual value creators—at a minimum, workers and taxpayers—on corporate boards. And we must exclude PVEs like Carl Icahn, Nelson Peltz, Paul Singer, William Ackman, Daniel Loeb, and Barry Rosenstein, to name a few of the worst.
I note that, in your review, you make no mention of Icahn as a PVE, even though we devote most of a chapter to him as an example of how, over decades, a leading PVE built his “war chest” by reaping where he had not sown. Our analysis shows how, through his wealth, visibility, hype, influence, and possibly insider information, Icahn put $2 billion into his pocket by buying, holding for about 30 months, and then timing the sale of Apple shares—while cajoling Apple’s weak CEO and his hypocritical board (one of whose longest-serving members is Al Gore) into setting records for buybacks in 2014 and 2015. We could have written a whole book of sketches of the predatory careers of, say, 10 or 12 hedge-fund activists (HFAs) along the lines of the one that we did of Icahn. But our time and other resources are not unlimited.
In your review, you imply that we should rely on another PVE, Jeffrey Ubben, to use his shareholding in a petroleum-refining company like BP—the largest share repurchaser in Europe over the past two decades—to get the corporation to shift out of fossil fuels into clean energy. Perhaps you think that Ubben is a value creator. If so, let’s discuss the source of his fortune. But there is a much larger issue here about how change occurs. We need a broad-based social movement to transform from fossil fuels to clean energy. Why on earth would we pin our hopes on any single individual to transform the investment activities of the petroleum refiners. Note that until Apple started to loot its own treasury in 2013, Exxon Mobil was the largest share repurchaser in history.
In our book we are critical of Robert Monks for helping to set in motion in the 1980s what has now become a corrupt proxy-voting system (see Jang-Sup Shin’s comments on your review of our book) that empowers these rapacious HFAs. If responsible shareholding means ensuring that pension funds get a steady stream of dividends from well-managed companies while leaving sufficient earnings with managers to sustain the innovative enterprise (as I have outlined above), then I have no problem with Monks’s approach. His weakness is the absence of a perspective on how a publicly listed corporation can be well managed as an innovative enterprise, and hence what a proxy adviser should advise. Monks did not, as far as I know, criticize buybacks, although at a conference to which I invited him in 2010 he did mention to me that, after hearing my presentation, he was surprised that the corporate cash spent on buybacks was so immense. I have subsequently had discussions with Nell Minow about the problem of buybacks.
As with Monks, you also saw my critique of Lucian Bebchuk and his brand of agency theory as an attack on one of your heroes. I have a problem with Bebchuk’s academic work for two reasons: a) as we document in chapter seven of our book, there is no substance to the critique he makes of incumbent management in Pay Without Performance: Bebchuk and Fried simply assert that managers are too powerful and harm shareholders, nowhere showing how the harm is done or even that shareholders are harmed; and b) his “empirical” response to Lipton, Strine, et al. in his 2015 article with Alon Brav and Wei Jiang fails to show whether changes in the five-year operating performance of firms in the large sample arose from hedge-fund activists’ contributions to value creation, as the authors assume, or from value extraction, which I would hypothesize in delving into firm-specific evidence. Because Bebchuk does not possess a theory of value creation, he cannot ask the question.
But because Bebchuk assumes that MSV is a theory of value creation, he argues that a supposed “improvement” in operating performance represents value creation because of the intervention of HFAs when it might represent just the opposite: HFA-induced value extraction that entails layoffs, wage cuts, price-gouging, tax avoidance, and accounting tricks. All the case evidence analyzed from the perspective of the theory of innovative enterprise supports the argument that the richest, most visible, and most powerful HFAs are PVEs. Wittingly or not, Bebchuk serves as an academic apologist for predatory value extraction.
Given that US households with savings rely on incomes from stocks held in pension funds and mutual funds, I think it is important that shareholder advocates like you have come out vigorously against stock buybacks. I, like you, have no faith in incumbent management whose purpose is MSV—they are the value-extracting insiders who have unlocked the treasuries of the companies that they are supposed to manage for even more extreme looting by the value-extracting outsiders. Stable and equitable growth of business corporations and the societies to which they are central depend on the decisions and actions of incumbent managers who have the abilities and incentives to retain-and-reinvest.
Advocates of long-term or responsible shareholding need to be clear about what good management does. It shares the gains with value-creating employees and, via the tax system, with households whose taxes finance government investments in knowledge and infrastructure of which firms make use. To change the system, advocates of long-term shareholding need to ally with forward-looking groups representing employees and taxpayers.
You argue that if employees have board representation, they will pursue narrow interests: “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.” The problem is that MSV has been used as a weapon to rob workers of wages that are warranted by productivity increases. And in well-managed companies, workers routinely generate productivity gains without employee ownership. They “participate” by coming to work every day, cooperating with other employees in the hierarchical and functional division of labor, and gaining productivity-enhancing experience and commitment through stable employment with equitable rewards.
Underpinning MSV and the branch of economics known as agency theory that has provided it with academic legitimacy is the “neoclassical fallacy” that the most unproductive firm is the foundation of the most efficient economy. If you or your readers doubt that PhD economists could be make such an absurd argument, I have an academic essay that shows when, how and why this “theory of the firm” became embedded in the microeconomics textbooks that have been foisted upon millions upon millions of college students for more than 70 years. The myth that workers are not productive, which is integral to the neoclassical theory of the firm, is used to rob workers of their earnings and employment for the sake of MSV. And when workers are in fact not productive, it is likely to be, I would argue, because of bad management by people in senior positions who, among other value-extracting practices, throw away billions of corporate dollars on stock buybacks, legitimized by MSV.
As a matter of law, employees sit on corporate boards in Germany as part of the system of codetermination. Unfortunately, the pandemic forced cancellation of a conference on German codetermination that I was to run in Berlin at the end of March. There is much to learn from the codetermination experience. I do not know anyone who would deny that it has had a positive impact on German productivity. The evidence is that, in periods when German industry has had to respond to new competitive challenges, codetermination has helped companies adjust wages and employment to the new reality as they have transitioned to new processes and products to keep the labor force productively employed.
Finally, the charge of feeding at the trough without adding to productivity can be made against shareholders. Our research on European companies shows that even when buybacks are not a problem—and they are much less significant in Europe than in the United States—dividend payout ratios are far too high to leave sufficient earnings for reinvestment. And we have some evidence that those senior executives who kowtow to shareholders who demand high dividend payouts lack the managerial capabilities to run innovative enterprises.
The corporate-governance challenge is to ensure that management allocates resources in ways that generate innovative products. I argue, moreover, that innovate enterprise enables the business corporation to meet the social-responsibility challenge of contributing to stable and equitable growth in the economy as a whole.
Many thanks to William Lazonick for this post on my review of Predatory Value Extraction. I added the introduductory paragraph, the embeded links, tags, and graphic, as well as the links below. — James McRitchie. Search William Lazonick for much more, including The American Corporation is in Crisis—Let’s Rethink It.
Lazonick Comments: McRitchie’s Reaction
I agree with your theory of innovative enterprise and much of what you further discuss above. A few quibbles below.
Yes, the stock market’s liquidity has traditionally allowed shareholders to exit easily. However, the rise of index funds and their overwhelming use in 401(k) plans makes that more difficult and increases the need for shareholders to focus on beta, perhaps more than alpha and proxy voting to ensure market values are better aligned with human values. That’s one of the reasons for my own focus on getting the SEC to require real-time disclosure of proxy votes in user-friendly format. See Mutual Fund Wars Over Fees AND Proxy Votes.
Yes, we need to debunk MSV, ban most stock buybacks, and place representatives of actual value creators on corporate boards. That is why I urge readers to submit comments to the SEC in favor of rulemaking petition File 4-746 to repeal and rewrite Rule 10b-18.
I will be filing proposals to encourage workers councils (see earlier post), as a step toward workers on boards, since more direct shareholder proposals on that issue have been unsuccessful. I admire the German co-determination model but see that as a bridge too far for the near future in the US. First, we would need much stronger unions, much more workers ownership, or both.
Although I would love to have taxpayer representatives on the boards of companies that have benefited from the value created by public expenditures, I have difficulty seeing how I can effectuate that. Maybe you have a better vision to make that happen.
I certainly did not mean to imply that we should rely on Jeffrey Ubben or others in the hedge fund industry to get Exxon Mobil to shift out of fossil fuels into clean energy. However, I do see a potential role for them, public pension and even sovereign wealth funds that have relied on fossil fuel revenues (such at Norges Bank) to help move that mountain. Agreed, the major lever for change will be public opinion, the pressure they can bring bear through political involvement, and their involvement in changing the mix of their own investments and how proxies are voted. (see Networking)
Yes, proxy advisors need to go beyond the traditional agency theory paradigm in analyzing proxies. They are improving their analysis of environmental and social impacts but still have a long way to go, such as moving in favor of proposal for worker representatives on boards and better analyzing the elements needed for corporations to be innovative enterprise.
Regarding buybacks, ISS seems more concerned with public relations than predatory value extraction. For example, there is the following from recent ISS policy guidance:
With respect to share repurchases, ISS’s policies generally recommend voting for the establishment of share repurchase authorities, provided certain conditions are met. However, ISS warns that actually conducting buybacks under these uncertain economic times and heightened public scrutiny of buybacks would invite ISS’s future scrutiny regarding the board’s ability to manage risk.
Last, you disagree with my argument that if employees have board representation, they will pursue narrow interests: “Workers will always want more in wages because they would not have to share that with other shareholders.” Perhaps this comes in part from my direct observations when workers at the Rath Packing Company bought their company in Iowa forty years ago.
Some workers thought they should be able to take their tools home from work because, as shareholders, they “owned them.” Although employee input greatly increased efficiencies at Rath, they could not compete with other plants with younger workers paid a fraction of what Rath employees earned, with gleaming new single-story processing plants and many other factors. Most of the workers at Rath were near retirement age (prior layoffs had come in order of seniority), so they were not willing to make the financial investments necessary to make Rath competitive. That probably made sense for most of them but, of course, it was a big disappointment to advocates like me.
Education of employees and managers on how to work together to be more innovative will be important going forward. I do think that widely publicly traded companies will only allow employees to hold and control minority stakes. If they hold controlling stakes, it would only be natural for employees to seek a higher proportion of profits distributed in wages than in dividends to outside investors. It will take a while to determine the right ownership mix to give everyone fair value. Of course, employees contribute much more to that value through their work than do investors, which contribute little more than liquidity in secondary markets.
Lazonick and I have much more in common with regard to how corporations need to be fixed than we have differences. While we work toward common purpose, it is great to be on the recieving side of his insights. I look forward to more.