Stakeholder Capitalism. Really?

A recent announcement by nearly 200 CEOs that corporations should serve more than the bottom line may be great public relations, but don’t hold your breath waiting for big changes in the way corporate America operates.

For four decades the popular conception is that a corporation exists to maximize returns to shareholders. This conceit is the work of economists. Milton Friedman, who was awarded the Nobel Prize in Economics in 1976, made the case in a famous 1970 New York Times Magazine article that the social responsibility of business is to increase profits. It laid the intellectual foundations for the shareholder value revolution of the 1980s.

As he put it “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits.” His former students popularized the idea that the great challenge of corporate governance is getting executives (agents) to act in the interest of the shareholders (principals).

This view caught on and became conventional wisdom, as universally accepted as the idea that the sun revolves around the earth once was. Over time the U.S. stock market has focused strongly on corporations’ quarterly earnings to the point that a penny up or down from expected earnings per share can cause the stock price to fluctuate.

This has created a number of potential problems. For starters the short-term focus of the stock market dictates a short-term approach by management, at the expense of long-term shareholder value. For example, management might decide to shower cash on shareholders and not invest in research and development on projects that would only pay off down the road. Also, market pressures could tempt managers to cheat or manage earnings to meet investor expectations, especially since the compensation of CEOs and other executives is linked to stock performance.

This August, nearly 200 chief executives of major American corporations including Apple, Amazon, General Motors, and Walmart – all members of the powerful U.S. Business Roundtable – announced that corporations should no longer just maximize profits for shareholders but also benefit other stakeholders including employees, customers, and citizens.

Is this all just rosy rhetoric or a real change in mission? Will these corporations who are people, really nice people, now use house money to support expansive social goals that are irrelevant to maximizing shareholder returns? This rhetoric about the purpose of a corporation won’t even rise to the level of the inconsequential unless executives address basic questions.

Will they argue for changes in how they are paid, how corporations are taxed and regulated and focus instead on the long-term health of their companies? What metrics will these executives use to measure stakeholder returns? How will corporations pivot away from the needs of activist short-term investors? How will they balance the needs of multiple stakeholders to create value for all these shared interests? How will executives resolve stakeholder conflicts? What tradeoffs have to be made? There are more unasked and unanswered questions than positions in the Kama Sutra.

New York Times Columnist Farhad Manjoo believes the new mission statement is all foam and no beer. He cynically says these CEOs want you to know how much they care, but they will continue to eat your lunch while virtue signaling. Many others are quite skeptical that corporations will change the way they behave.

Former General Electric CEO Jack Welch said in a 2009 interview with the Financial Times that: “On the face of it, shareholder value is the dumbest idea in the world.” This comment may be the height of irony given that when he ran GE, the firm consistently met or beat analysts’ quarterly earnings forecasts.

One thing is for certain. The time is long overdue to shift the focus of corporations away from maximizing shareholder value and stock-based executive compensation. But don’t hold your breath. This is like asking business executives to perform surgery on themselves.

The Merrill Lynch story

The weekend of Sept. 13 and 14, 2008 was one of the worst ever on Wall Street. And when Lehman Brothers went bankrupt on Sept. 15, it triggered a global financial panic.

Also over that weekend, Bank of America and Merrill Lynch hammered out one of the biggest deals in Wall Street history in less than 36 hours. The feds pushed for a deal to prevent Merrill from becoming the next domino to fall. With Lehman preparing to file for bankruptcy after failing to find a buyer, executives at both Bank of America and Merrill knew they needed to act quickly as Merrill’s liquidity was evaporating.

Merrill Lynch was founded in 1914 by Charles Merrill and his friend Edmund Lynch. During the next 30 years, it grew by a series of mergers and acquisitions into the nation’s largest and best-known retail brokerage firm. Just as Lehman Brothers had epitomized the “aristocratic German-Jewish culture” in the financial industry, Merrill Lynch became a symbol of “working-class Irish Catholic culture” (like New York City’s police and fire departments). Not that it mattered much when push came to shove in September 2008.

In 1971, Merrill Lynch became a publicly traded corporation. And in 1978, it acquired the small but prestigious investment bank White Weld & Company to expand its underwriting activities and take advantage of the ability of its huge retail brokerage arm to place new common stock issues with investors directly rather than through syndicates composed of other firms.

But by 2000, Merrill (like Lehman and Bear Stearns) was becoming increasingly dependent on its collaterized mortgage obligations business to grow profits. By goosing this growth by more than doubling its 2003 leverage ratio of 19-1 to 39 to 1 in 2007, Merrill was able to provide its common stock holders with a 13 percent increase in investment returns during this period.

By 2006, Merrill had leaped to the top spot in the nation’s collateriized mortgage obligations business, underwriting $35 billion in these securities, 40 percent of which were backed by sub-prime mortgages. To help secure its position, Merrill spent $1.3 billion to acquire First Franklin, one of the nation’s largest originators of sub-prime residential mortgages. This gave it a major in-house mortgage originator and reduced its dependence on buying mortgages from numerous banks and home loan firms to back new underwritings of collateralized mortgage obligations.

Concerns about Merrill’s viability increased during the summer of 2007, when two Bear Stearns hedge funds defaulted. As a short-term lender to these funds, Merrill seized $800 million of Bear’s mortgage assets and proceeded to auction them off in the secondary markets. But the auctions failed to generate reasonable bids for the sub-prime mortgages and highlighted Merrill’s exposure to these “toxic waste securities”. For the last quarter of 2007 and the first three quarters of 2008 combined, Merrill wrote down more than $46 billion to bad bets on real estate and other mortgage-related instruments.

These write downs had severe consequences for Merrill: the firm’s stock price fell significantly, Moody’s Investors Service placed Merrill’s long-term debt “on review for a possible downgrade”, traders in other firms lost confidence in the firm’s ability to meet its trading obligations, and the firm had to increase its equity capital by selling off assets such as its 20 percent stake in Bloomberg for a much-needed $4.4 billion.

Additionally, between May 2007 and September 2008, Merrill laid off over 7 percent of its employees. Its board ousted CEO Stan O’Neil in October 2007, though he retained $30 million in retirement benefits and $129 million in stocks and options.

Merrill’s continued write downs of toxic mortgage assets, increasing operating losses, difficulty refinancing its short-term borrowings made it clear that its days as an independent firm were numbered. On Sept. 14, 2008 Merrill agreed to sell itself to the Bank of America.

Financial markets are prone to instability. But when paired with excessive financial leverage, the result can be severe economic pain.