The Sham of Shareholder Capitalism

Yves here. While Richard Murphy makes some important points in his post, he unwittingly implies that shareholder capitalism could work as advertised absent the way investors lose ownership rights when they acquire stock through pooled vehicles.

In fact, the choice that legislators and regulators made to promote liquidity in stock markets inevitably resulted in weak governance. From a 2013 post:

Amar Bhide, now a professor at the Fletcher School and a former McKinsey consultant and later proprietary trader, questions the policy bias towards more liquidity in financial markets. Officials (and of course intermediaries) favor it because they lower funding costs. Isn’t cheaper money always better? Bhide argues that it can come with hidden costs, and those costs are sometime substantial.

He first took up the argument in a 1993 Harvard Business Review article, “Efficient Markets, Deficient Governance.” Its assessment was pretty much ignored because it was too far from orthodox thinking. He started with some straightforward observations:

US rules protecting investors are the most comprehensive and well enforced in the world….Prior to the 1930s, the traditional response to panics had been to let investors bear the consequences……The new legislation was based on a different premise: the acts [the Securities Act of 1933 and the Securities and Exchange Act of 1934] sought to protect investors before they incurred losses.

He then explained at some length that extensive regulations are needed to trade a promise as ambiguous as an equity on an arm’s length, anonymous basis. Historically, equity investors had had venture-capital-like relationships with the owner/managers: they knew them personally (and thus could assess their character), were kept informed of how the businesses was doing. At a minimum, they were privy to its strategy and plans; they might play a more active role in helping the business succeed.

By contrast, investors in equities that are traded impersonally can’t know all that much. A company can’t share competitively sensitive information with transient owners. Stocks are also more liquid if ownership is diffuse, which makes it harder for any investor or even group of investors to discipline underperforming managers. It’s much easier for them to sell their stock and move on rather than force changes. And an incompetent leadership group can still ignore the message of a low stock price, not just because they are rarely replaced, but also because they can rationalize the price as not reflecting the true state of the company compared to its competitors, which is simply not available to the public.

Bhide’s concern is hardly theoretical. The short term orientation of the executives of public companies, their ability to pay themselves egregious amounts of money, too often independent of actual performance, their underinvestment in their businesses and relentless emphasis on labor cost reduction and headcount cutting are the direct result of anonymous, impersonal equity markets. Many small businessmen and serial entrepreneurs hold the opposite attitude of that favored by the executives of public companies: they do their best to hang on to workers and will preserve their pay even if it hurts their own pay. Stagnant worker wages and underemployment are a direct result of companies’ refusal to share productiivty gains with workers, and that dates to trying to improve the governance problems Bhide discussed by linking executive pay to stock market performance. That did not fix the governance weaknesses and created new problems of its own.

An issue that we’ve also discussed regularly is that the idea that companies are to be operated for the benefit of shareholders is an idea made up by economists with no legal foundation. Equity is a weak and ambiguous claim: you get a vote on some matters, you get dividends if we make money and even then if we feel like it, and we can dilute your interest at any time. Equity is a residual claim, the last in line after everything else is taken care of.

By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK

The FT published a report last week that commented on an important issue. That is the collapse of shareholder capitalism.

The issue is a simple one to summarise. Apparently about two thirds of all private owners of quoted shares in the UK now own their shares through nominee pooled funds. As such they are not recorded as the legal owners of these shares. They have no voting rights. And no right to attend shareholder meetings. They don’t even have the right to accounts. And they have given an institution, who does not own the shares in reality, the right to exercise their vote in the company.

This matters for a number of reasons.

First, this makes a mockery of shareholder capitalism. The company has no idea who its shareholders are. And it is wholly unaccountable to them. The idea that somehow shareholders are at the centre of corporate concern is shown to be a sham, yet again, by this.

Second, this undermines audit. Bizarrely, audit reports are still addressed to shareholders. What is apparent is that many do not get them. No wonder auditing is becoming so removed from reality.

Third, this breaks down any pretence that there is effective corporate governance. There cannot be when many company members are disenfranchised.

Fourth, the concentration of power in the hands of passive nominee owners reinforces the control of a small ruling elite in quoted businesses, who are insulated by this arrangement from any real accountability whilst being able to pretend that it exists.

Fifth, this means tax fraud can be much more easily disguised.

And lastly, it shows the owners of shares just don’t care and so are not the custodians for business that we need.

In essence, we have a form of capitalism that claims to be for shareholders and yet that is clearly a sham. No wonder it is not working.

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17 comments

  1. Tomonthebeach

    Most shareholders lack the savvy to fuss over board member actions. So, today we have mutual fund manager capitalism. It might work better. If I own 100 shares, who cares? If I own 1,000,000 shares, board’s better listen. Now if we can only get our mutual funds to kick ass about abuses like bonuses for failure, worker abuse, etc.

    Reply
    1. Phacops

      Activist fund managers? Nope. Several years ago, and despite pointing out that high executive compensation injures shareholder value, I was told that there is no interest in voting shares to limit compensation of executives.

      Reply
      1. Off The Street

        Fourth, the concentration of power in the hands of passive nominee owners reinforces the control of a small ruling elite in quoted businesses, who are insulated by this arrangement from any real accountability whilst being able to pretend that it exists.

        Those nominee owners don’t seem all that passive. Pay no attention to that man behind the curtain.

        Reply
      2. John Wright

        Note, Warren Buffet disagreed with a Coca Cola pay package, but he could not actually vote against it (he abstained).

        See https://www.businessinsider.com/warren-buffet-v-coca-cola-plan-to-pay-executives-13-billion-2014-10

        “Warren Buffett is the largest shareholder in Coke with a 9.1% stake in the business. He had abstained from voting through the original pay guidelines, saying at the time “I could never vote against Coca-Cola, but I couldn’t vote for the plan either.”

        So much for investor activism on Buffett’s part.

        The article is titled “Warren Buffett Wins A Battle Against Coca-Cola’s Plan To Pay Its Bosses $13 Billion” even though Buffett could not find his way to actually vote AGAINST the pay package and abstaining simply means one’s vote isn’t counted.

        If independently wealthy Buffett cannot find the courage to vote against a pay package he finds egregious, one wonders if other fund managers, of lower independence and wealth will show much activism in bucking corporate management.

        Reply
        1. FDR Liberal

          Buffett’s stance on Coke execs pay raises was at best a punt and at worst an abandonment of classical capitalism’s sine qua non. Buffett, similar to Blackrock, Vanguard, own multiple stocks in the same industry, have cozy relationships with boards, ceos, etc.

          Corporate capitalism is not capitalism. It has evolved into what Marx accurately predicted is fictitious capital.

          Reply
  2. Ape

    Coase’s theorem isn’t a theorem — and it’s not even right! Worshipping liquidity so that equilibrium models fit (which is backwards, right?) is insane. Coase is a religion, not a scientific model (and definitely not a theorem).

    And these kind of things show how bad an equilibrium analysis is of economic systems. Even the tiniest bump in the manifold, and you get turbulence which can lead to storms. Dumping liquidity into a turbulent system and you get more turbulence (which eventually becomes self-sustaining structures in the face of the very even flow you were trying to create…)

    Reply
  3. Steve Ruis

    I mis-read the lead as “The Shame of Shareholder Capitalism”. Whatever happened to corporations that had responsibilities/commitments to anything besides shareholders? Since said shareholders are, in effect, absentee landlords, executives are running the game for what? Their own benefit? I’m shocked, shocked I tell you.

    Reply
  4. Oh

    The major shareholders, mostly the CEO, CEO et al, are there to feather their own nest. While the right wingers repeat that the corporation should take care of shareholder interest, they actually mean these majority shareholders, who loot the corporation for their own benefit.

    Reply
  5. caloba

    I’ve always been struck by one contradiction inherent in the pooled fund model, with its customary emphasis on performance relative to indices or comparable funds. If an extremely large mutual fund goes underweight a listed stock (relative to its target benchmark index or the competition) you could easily end up with the largest holder of that stock having a financial interest in the stock’s underperformance.

    Reply
  6. Norm

    A theoretical economic justification for almost any aspect of large scale capitalism is prima facie ridiculous. Like everything else, capitalism is a game of power and although it’s pleasant to dream about countervailing power being held by consumers, investors, competitors and employees, the only enduring form of resistance to CEO governance is government. Unfortunately, the part of government that has been charged with controlling the corporation has been AWOL for a long, long time. The Democrats, the supposed champion of everyone who is not a CEO have long ago crossed the line and serve the other side (hopefully, prayerfully, with some exceptions).

    Just as an exercise that might shed light on the effectiveness of the funds (hedge & mutual) ability/willingness to constrain the CEOs, it would be interesting to know how frequently these funds put forth any resistance to debt funded stock buy backs, which, at least temporarily, enhance the funds’ holdings.

    Reply
  7. Generalfeldmarschall von Hindenburg

    When you examine the deep structure, isn’t Wall Street really just an American version of GOSPLAN?

    Reply
  8. Susan the other`

    Liquidity. Without it the system doesn’t work and is prone to freezing up. So naturally, shareholders looked like liquidity incarnate in 1990. Liquidity made more urgent by all the mismanagement of the economy and the inability to understand and control inflation; Paul Volker’s rate hike. And to make those nominee funds look like honest business Milton Friedman began to tout shareholder rights and values. It makes sense – how it all happened. I remember thinking, What happened to good old fashioned capitalism? more than once. This went hand in hand with the new and improved MBA, preferably from Harvard and the valuation of efficiencies that were short sighted and superficial. How many corporations got rid of their excess baggage, fired all their old hands, hired new managers, etc? Then off-shoring. It amounted to decimation in order to free up liquidity – sounds like an oxymoron now. It was based on nothing more than optimism. Which to my thinking runs sorta parallel to ponzi. It was inevitable that shareholder capitalism was used as an excuse for tax loops and fraud. Agents, “nominee funds”, are happily removed from reality. It became open season for private equity, money laundering, whatever. Liquidity became synonymous with profit taking. All those equities were “ambiguous promises…” which were nothing more than “residual claims” offered by nominee proxies offering no good corporate governance. So the question pops up, What happens now that liquidity has blown itself up? Its fitting that all the central banks are infusing money into the system as fast as they can because they must balance out the massive inequality that occurred – even though that money isn’t getting to the right party. It’s so beyond nuts. How do we make things work again? And so to the point – what does a share really mean – does it carry both rights and obligations?, what does it mean to be a shareholder and what are the corporate obligations to shareholders and to society? -to labor (therefore to management and good corporate governance). All those questions just got left in the dust.

    Reply
  9. readerOfTeaLeaves

    Sincerely appreciate this post.
    I hadn’t connected several dots in quite this way before.

    Reply
  10. OpenThePodBayDoorsHAL

    Until 1982 it was illegal for a company to borrow money in order to buy back their own shares. Il-Le-Gal. Because it was so obviously share price manipulation by insiders.

    Just reinstate that, and clean up shareholder options issuance while you’re at it.

    Result? Share prices would more accurately reflect the company’s financial performance. You remember that stuff: things like earnings per share, market share, new product launches, cost containment. Good governance would follow.

    Instead what we have today is just one big casino, run for the benefit of insiders.

    Reply
  11. RBHoughton

    Very grateful for this bit of rare clarity about financial intermediaries and the games they play.

    Back in the beginning of joint-stock companies everyone knew they were dodgy investments run by dodgy people. You put only a small amount of your capital in them and the bulk in government stock.

    Now they have bought the protection they need, secured limited liability for their acts and got a corrupt Treasury to enact that a company is a person. Speaks volumes about our political representatives.

    Reply
  12. Tom Bradford

    A sensible article from the viewpoint of one outside looking in. But as I see it Murphy is still living in the 19th Century.

    Me? I’m retired and have $100,000 to invest for an income to sustain me. I can invest that $100,000 in one company, pore over its accounts, watch its director’s every move and snap at their heels if I don’t think I’m getting the return I should be. Of course if it’s a $1billion company my snapping isn’t going to have much effect. And if the Company goes under I’ve lost my retirement savings.

    Or I could invest $10,000 in ten companies. I’d have to choose the ten, of course, on the basis of public information and wouldn’t be able to scrutinize them all equally, and my stake would make my snapping at the heels of the directors even less of a consideration. However I have only a 10% chance of a total loss, and a 10% chance of sharing any spectacular success.

    Or I could put the $100,000 in a managed – or even a passive – fund. There I’d have less than a 1% loss if the Company goes under and a return that should pretty much reflect what the general economy was doing. I’d only get a tiny slice of any spectacular commercial successes, but that’s the consequence of not gambling which is what choosing to invest in one or two companies in fact is.

    In short, for someone in retirement, pooled investment makes the best sense. And while I don’t know the actual figures I would be prepared to gamble a small amount that a considerable slice the total amount invested in the stock market is ‘owned’ by the retired, or the sooner or later to be retired.

    Reply

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