Essay on Corporations, Executive Greed, and Owner-Managers

Corporate Motivation

If a person is an economic being and figures out the odds, then there is a very high incentive to cheat. That is, of course, putting aside honor, duty and patriotism.
Jerome Kurtz, former Commissioner, Internal Revenue Service
(Wall Street Journal, April 10, 2020)

Corporations are legal entities without emotions, brains, or personality created by governments.

The major players in capital markets, such as issuers, mutual funds, investment banks, and insurance companies, are usually corporations and therefore, as legal abstractions, cannot have desires or impulses.

We find corporate motivation by studying the people with power to pull the levers

These human urges must come from the people with the ability to direct or influence corporate actions – managers, shareholders, labor union executives, suppliers, government officials, and customers.

We begin Capital Flow Analysis by presuming that issuers dominate the equities market.

Our first goal, therefore, is to explain the actions of issuers. We can only find what motivates business firms by studying the people with the power to pull the corporate levers.

Diverse groups strive to rule the corporate entity. Some contenders are organized, ruthless, and clever. Others are weak and slow. Each faction consists of individuals with assorted vices, virtues, and economic self-interests.

To define 'corporate motivation', we must look for generalizations to describe each group, portraying a crowd as a single abstract individual.

For the purposes of analysis, there is no utility in trying to be equitable to individuals or to single out personal behavior.

However, it is useful to characterize group behavior as ethical or otherwise, since when groups act dishonestly or unfairly, although no one admits it at the time, bad customs may eventually be recognized and lead to change.

Useful Generalization

Corporations and abstract groups of individuals are not flesh and blood. In explaining capital flows, it is useful to use cartoon-like simplification.

We talk about economists, MBAs, Baby Boomers, fund managers, auditors, company executives, and the many other market players as if the people in each category were alike, when this is never the case.

'Risky generalization is one of the methods by which knowledge proceeds'

Furthermore, an individual might be an economist and a company executive simultaneously, or an auditor today and a fund manager tomorrow.

However, we need to generalize, and as Joseph Epstein, the editor of American Scholar, noted, 'Generalization, especially risky generalization, is one of the chief methods by which knowledge proceeds.' ('But I Generalize,' from ' The Middle of My Tether', Joseph Epstein, W.W. Norton [1983].)

Generalization will certainly be offensive to many members of the abstract groups to whom we attribute behavior.

Moreover, most of us are guided by norms and customs of the society in which we live.

At times, I have been a college student, a draftee in the army, a commercial banker, an economist, a stock broker, a fund manager, an investment underwriter, an auditor, a corporate executive, a government advisor, an entrepreneur, a parent, a financial advisor, a security analyst, and many other things, but I have no inclination to defend or condemn others in these categories. If I make unflattering generalizations about executives, this is not to acknowledge flaws in my own actions as an executive or even to attack other managers.

Individual morality and ethical behavior to deserve condemnation requires awareness and freedom of choice, and most of us, most of the time, live under rules and customs created by others, often before our time – rule-makers that are to us unknown and dissociated from the current scene.

Nevertheless, generalization is a handy analytical tool to make sense of capital flows.

Using What We Know

There are many sources from which our generalizations spring. First, we may use our experience. As we grow older, our store of experiences becomes richer.

When I comment about corporate executives, my views reflect my having been an executive of large and small companies and having observed other executives while working forty years in capital markets, studying companies as a securities analyst, advising managers as a consultant, selling goods and services to decision makers, and reading about companies and their businesses.

In Capital Flow Analysis, 'better is the enemy of good'

Because life is short and our brains are limited, we cannot gather and process the universe of knowledge and fully understand the actions of any class of people.

My perception of executive behavior is probably better than that of a college freshman, but perhaps not as good as that of someone with a wider background or deeper insights.

If, as analysts, we postpone conclusions until we have perfect information and discernment, our work will have no practical use. In Capital Flow Analysis, 'better is the enemy of good'.

We must resort to generalizations or abandon our task.

Sometimes we may be able to rely on accurate, formal research to buttress our generalizations. We may have access to behavioral surveys, polls, and structured sociological studies.

I have had one opportunity to conduct deliberate social research on executive motivation – an opinion survey of executives on long-term bond financing, combined with flow of funds analysis, undertaken in Brazil during the 1970s with government financing.

However, to direct such surveys is costly, time consuming, and usually beyond the means of an analyst.

Sometimes, through library research or the Internet, we may locate surveys done by others that answer a particular question, but the scope of Capital Flow Analysis is too broad to have definitive research to support most generalizations that we must make.

We are constrained to conclusions inferred from commonsense and limited observation

Executive Greed: Historical Comparisons

In seeking to explain group behavior, we may examine history and try to spot shifts in the group ethos that might have influenced the flow of funds.

Just as a white rabbit becomes visible when it moves against the snow, the behavior that influences capital flows becomes apparent when we notice historical change.

It is often easier to evaluate today's behavior by seeing differences in customs of earlier periods.

For example, in 1941, the top salaries of executives of good-sized companies were about $195,000 , which adjusted for inflation, would be $1.8 million in 1998 dollars. ('Economics: The Original 1948 Edition', Paul Anthony Samuelson, McGraw-Hill Trade, 1997)

In comparison, average executive pay of chief executives in 1998 was over $5 million, with top pay, such as that of Sanford I. Weill, CEO of Traveller's Group, exceeding ninety million dollars.

Over fifty years, executive pay increased forty or fifty times faster than the cost of living

Because the remuneration of top executives increased forty to fifty faster than the cost of living, management remuneration is relevant to understanding corporate motivation.

Furthermore, since executives were able to control their own paychecks, we may generalize and make a value judgment, saying that executives have become increasingly greedy.

Obviously, out of hundreds of thousands of executives, some have had their salaries reduced or have foregone using power to benefit themselves out of a sense of duty to shareholders.

However, the characterization of corporate executives as having become excessively piggish and predatory is sufficiently accurate to be useful in Capital Flow Analysis as we seek to understand the motives of corporations.

Our basis for inference may be library research or, if we are old enough, our own memories about how things used to be.

To explain the Great Bubble, we may look into the shifting attitudes of market players over many decades.

To explain a market, we need a hypothesis

When, for example, we say that executives are venal or failing in their fiduciary duty, the standards are historical, based on personal observations from decades long gone or on the writings of others, recorded in biographies, contemporaneous diaries, or historical research.

Just as a security analyst cannot be sure of intrinsic value, we cannot be certain of correctly identifying group motivation. However, to explain the market, we need a hypothesis.

We must compose a story that hangs together and makes sense.

With limited time and resources, the explanation of one analyst will certainly differ from that of next, but by gathering more information and insights, our story will develop over time, forming an evolving hypothesis that we hope will become ever more useful in guiding investment decisions.

Traditional Owner-Managers

Corporate stakeholders include governments, shareholders, management, labor, creditors, customers, suppliers, and trustees.

Each stakeholder contributes something to the organization and expects something in return, often at the expense of the others.

Corporations create wealth and the stakeholders compete for a share of the spoils.

The stakeholder that always prevails is the government — the creator of corporate life

This struggle is a continuing political theme. The winners change with the country and the times.

In the last decade, the phrase 'corporate governance' has become a buzzword for the battle between stakeholders for a share of corporate treasure and power.

The stakeholder that always prevails is the government – the creator of corporate life with power to trump all others.

The government ultimately determines the behavior of management and shareholders.

When people own enough shares to assure their election as corporate managers, the interests of shareholders and management come together and the company may act like a rational investor.

These 'traditional owner-managers' seek wealth through ownership of profitable companies that pay generous dividends.

They want to keep stock for the long term, because they regard regular dividends as more valuable than one-time capital gains.

Besides, holding stock is essential for control – a precious asset in itself.

Today's owner-managers are similar to capitalists of the nineteenth and early twentieth century, but with differences that relate to changing public expectations, taxes, and government rules.

Owner-managers are like capitalists of the 19th and early 20th century.

Owner-managers might use company reserves to buy back shares and manipulate prices, if encouraged by tax policy and minority shareholders, as long as this does not result in loss of control.

However, their primary goal is to administer assets and people for the long-term, building permanent wealth, rather than temporarily increasing stock values on the exchange.

Traditional owner-managers sometimes overlook their own financial self-interest, out of pride or loyalty to employees or community. They may persist in running a business, in the face of declining revenues, to avoid closing plants and putting people out of work.

Their values include loyalty, honesty, and community spirit. Closely-held businesses (usually small and unrelated to the stock market) create most new jobs in the United States.

A Patriarchal Company

In the 1950s, I visited Companhia Petropolitana, a nineteenth century textile mill that still operated in the mountains behind Rio de Janeiro.

This vertically integrated factory processed raw cotton, made thread, and wove finished cloth.

Some old-time capitalists had a sense of noblesse oblige

This patriarchal company owned and ran a tiny town with workers' homes, a school, a church, a clinic, and a soccer field.

Descendants of the founders told me that consolidation of operations protected their supply of raw materials and labor.

They felt that workers were under their care.

There was a sense of noblesse oblige.

Adequate corporate reserves assured continuity of the community. To be dependent on outsiders was to invite trouble.

Today, this factory no longer operates and is a historical museum.

Modern markets have made it possible to rely on others, reducing the need for vertical integration and the company town.

However, the sense of long-term fiduciary management has also been lost.

The old Petropolitana factory, in the mountains above Rio de Janeiro

Old-time capitalists had little interest in financial benchmarks like earnings per share.

Cash, not statistics or performance indices, was king.

In the 19th century, cash, not performance indices, was king

In the nineteenth century, capitalists valued corporate cash as a bulwark against financial panics that struck every few years.

Companies needed reserves to guarantee a steady supply of raw materials and labor. Competitors could squeeze a company that was not self-reliant.

Nineteenth century executives focused on tangible goals such as completing a railway, building a bridge, producing more pig iron at less cost, or manufacturing so many million square yards of textiles. They expected the world to recognize their contribution to progress.

Responsibility and Reputation

At the time of the American Revolution, there were few corporations. Distrust of corporations ran high – a legacy of resentment against British colonization.

Enterprises were tiny and simple by today's measures.

In the early United States, government and business was small and local. The states could authorize corporations, but did so reluctantly, with franchises for limited periods and with restricted aims.

In the 19th century, the threat of bankruptcy guided Adam Smith's invisible hand

Most nineteenth century American businesses were proprietorships or partnerships, and their owners were constrained by unlimited personal liability.

The threat of bankruptcy guided Adam Smith's Invisible Hand. Communities were compact and debtors and creditors often knew each other.

Reputation was critical to business success.

Professionals, such as doctors, lawyers, accountants, and stockbrokers, were responsible for their actions and – until the closing decades of the twentieth century – were not permitted to limit financial liability by incorporating.

Most nineteenth century owner-managers possessed high integrity by today's standards.

Traditional nineteenth century capitalists were concerned with their reputation for 'plain dealing' – their term for honesty. A common saying was,

'Who steals my purse, steals trash. Who steals my good name, steals everything.'

Bankrupts, with nowhere to hide their shame from neighbors, would 'Go West' or spend a lifetime repaying creditors, although not legally required to do so.

Although the United States had no debtors' prisons, the social stigma of financial failure stiffened the moral fiber of the people that ran their own businesses – the majority of the population.

Relativistic Morals and Ethical Decline

Traditional capitalists, with goals consistent with the needs of small investors, distributed handsome dividends, dealt harshly with competitors, and, while creating most jobs, paid employees only what the market required.

The moral restraints of the 19th century are now largely gone

Today, this kind of capitalist has been replaced by hired-professionals that eschew dividends, mislead shareholders, remunerate themselves lavishly, and fire workers en masse for transitory, cosmetic improvements in earnings per share.

The moral restraints of the nineteenth century are now largely gone.

Most people are employees and personal responsibility is of little concern.

New virtues, based on supposed rights of privacy, the absolution of debt, the succor of so-called 'minorities' and other self-proclaimed victims, and personal anonymity, are now in fashion.

In December 2001, the Enron Corporation filed for bankruptcy, causing losses of over sixty billion dollars to investors and creditors, revealing, at the time, the largest financial failure in history, surpassing the collapse of Argentina in the same month.

However, most of Enron's top executives showed no shame or contrition, retiring with hundreds of millions of dollars in riches, while employees, shareholders, and creditors were devastated. Unlike nineteenth century failures, Enron executives did not offer to repay those who had entrusted assets to their care.

Clinton Era Baby-Boomers had reversed and corrupted the nineteenth century adage and now said,

'Who steals my name, steals trash.'

There are millions of corporations worldwide, but less than one hundred thousand have stock listed on exchanges.

In developing countries with small capital markets, owner-managers are still supreme.

Traditional capitalists run many of the foreign companies that now dominate the supply of new equities on Wall Street.

However, owner-managers no longer control most large American public companies.

Three Types of Control

To simplify Capital Flow Analysis, we may divide corporations into three classes.

The Value of Hired Managers

Professional managers cannot become extremely wealthy by selling their services on an open market.

With six billion people on the planet, there are far more candidates competent to run large companies than there are openings.

There are more competent candidates to run large companies than there are openings

Executives know that many are ready and eager to fill their positions. Companies have failed due to a bad choice in managers, but never due to a lack of managers from which to choose.

Employee-executives understand that it is unlikely that they will become rich in a free labor market or as long-term, small investors in the companies that they run.

Therefore, they manipulate the election of directors, bringing together friends, cronies, and useful fools that will reward them with fat salaries, stock options, exorbitant severance packages, and generous retirement plans, while ignoring any duty as fiduciaries for distant, permanent shareholders.

Such hired-professionals are willing to defraud company owners with stock repurchases, options, and misstated earnings, justifying their actions by rationalization and citation of management-friendly government regulations, while easily suborning the support of stockbrokers and fund managers.

By the twenty-first century, these hired-managers ruled Wall Street.

Traditional capitalists now lurk on the fringes of securities markets, in small businesses that create new jobs and lead in technological innovation, or in foreign markets where family-owned businesses still control the largest corporations.

Management Recruitment: Pseudo-Science

High management salaries represent a type of insurance against possible failure in replacing managers.

Although there are millions who are competent to run large corporations, there are many more millions without such abilities.

Personnel selection is akin to astrology and phrenology

Personnel selection is more akin to astrology or phrenology than to science. Rather than risk change, even moderately competent managers easily convince board members to increase executive pay rather than risk their leaving the company.

Non-owner directors, although pompous in demeanor, are by nature subservient and risk-adverse, inclined to bow to the wishes of entrenched management.

Professional managers are now the darlings of Wall Street, fund managers, and venture capitalists. This latter group consists of speculators that finance new business with the intent to sell out promptly.

They supply funds bit-by-bit to cash-strapped entrepreneurs and are ready to cut and run, abandoning long-term projects at the first sign of difficulty.

Their goal is to take control and, as soon as possible, replace innovators by professionals skilled in the arts of manipulating financial statements and enhancing stock prices.

Venture capitalists try to turn capital over quickly at twenty times cost, even before a company earns a cent of profits.

Professional managers are now the darlings of Wall Street.

Although the ultimate investors are still individuals with extreme long-term goals, the intermediaries that now handle their money – fund managers and venture capitalists – are driven by short-term gains.

Degrading Capitalism

Traditional capitalists have always been essential to progress in the United States.

Even today, there are many more closely held businesses than public companies run by hired-professionals, although most privately controlled companies do not have securities listed on the stock exchanges.

Employee-managers have taken over the organized investment markets.

Those who would believe the Common Stock Legend should remember that those who control public companies today are not the same kind of people that built Industrial America.

Some of the most successful nineteenth century capitalists despised Wall Street. For every Jay Gould or Jim Fisk, there were hundreds like Henry Ford, Harvey Firestone, or Thomas Edison, driven to produce goods to advance civilization.

Andrew Carnegie was a poor immigrant who rose to become 'the richest man in the world' by creating steel mills that produced iron at ever-lower cost. Before he died, he gave away most of his money.

Men like Leland Stamford, Ezra Cornell, Enoch Pratt, Peter Cooper, and George Eastman made money by helping to develop a nation and then using their wealth for good works.

Most of the great nineteenth century industrialists understood the good they were doing and naively expected gratitude.

However, they also built palaces and flaunted wealth, attracting envy and hate.

The spotlight of fame revealed personal shortcomings, like Henry Ford's anti-Semitism and strange beliefs about eating salt.

Failed competitors harbored resentment.

Immigration and the displacement of farmers to the cities kept factory wages low, giving rise to socialist agitators and labor unions.

Intellectuals, inspired by Karl Marx, lodged in the great universities and found fame by blackening the reputation of practical men who had advanced the world. Muckrakers called them robber barons.

Franklin Roosevelt, pushing Big Government, slurred business owners as 'economic royalists'.

By fanning envy, and by stressing the unequal distribution of wealth, jealous scribblers, like Gustavus Myers in the History of the Great American Fortunes, shifted attention of the resentful intellectual mob from the deeds and progressive triumphs of the traditional capitalists to their money and lifestyles.

If we remember our capitalist ancestors today, it is because they founded universities, museums, and libraries that still bear names that no one has yet been able to scrape from the lintels.

Mount Rushmore shows the faces of politicians, not capitalists.

Mount Rushmore shows the faces of politicians, not men who built electric lines, steel mills, and factories.

Moral stories of Thomas Edison, Henry Ford, and the Wright Brothers have been scrubbed from schoolbooks, replaced by legends of Martin Luther King, Rosa Parks, and John F. Kennedy.

Although America thinks itself as a great capitalist nation, there is no national holiday honoring a capitalist.

Americans name their bridges, highways, airports, and public schools to pay tribute to crooked politicians and venal public servants.

There has been much rewriting of history. However, despite active use of the Orwellian memory hole at liberal universities, a useful appraisal of traditional capitalists can be found in works such as Paul Johnson's History of the American People.

New historians are even beginning – finally – to debunk the perennial myths of the New Deal.

Who Are Our Heroes?

In today's democracy, the masses honor sports heroes, fashion designers, and movie stars rather than builders of factories and inventors.

Although much has been made of innovation and productivity in recent years, a poll in a public mall will find few shoppers who can name three living Americans with the stature of an Eastman or a Carnegie that have been responsible for America's vaunted technological progress.

The people now associate successful capitalism with names of vain self-promoters like Rosie O'Donnell, Bill Blass, Martha Stewart, Calvin Klein, Donald Trump, Tommy Hilfinger, George Soros, and Ophra Winfrey.

In the 1990s, the government – boasting of questionable progress and ignoring the pilfering of hundreds of public companies by hired-managers – tried to break up Microsoft Corporation – a company recognized worldwide as a symbol of American technological leadership.

Bill Gates, the founder and a traditional capitalist, had ignored the lessons of the nineteenth century and had allowed himself to become a public figure, perhaps expecting gratitude for having promoted a standard operating system that made it possible for competing manufacturers to reduce the price of the home computer.

The income tax provides the motive for those that build and control corporations to sell out, taking profits as capital gains rather than dividends.

There are no tax incentives for innovation or for creating things.

The tax rate for the brilliant scientist whose discoveries save lives is the same as the rate for the stupid prizefighter, football player, or lottery winner.

The government's message is that the way we make money is irrelevant, as long as we pay taxes, keep within the law, and avoid loading the dice on Wall Street or Las Vegas.

The Securities Exchange Commission views the capital market as a casino, in which the agency's mission is to maintain a 'level playing field' for gamblers.

The SEC has brought many cases for market manipulation and insider trading – offenses against the interests of short-term speculators.

Other than matters of disclosure or insider trading, there have been few cases brought for violation of fiduciary responsibility by employee-executives.

In fact, such abuses are often not within the mandate of the securities market regulator.

Managers Learn to Loot

Today's professional managers have learned the lessons of the past. The income tax institutionalizes envy by purporting to take more from the rich, teaching us that we must not let others know how much we have – especially with the IRS paying bounties to those who spy on neighbors.

The death tax teaches that government does not want entrepreneurs to build businesses that they can pass on to their children.

The young MBA learns that it is best to become rich on the sly, since fame may attract the IRS, government regulators, kidnappers, and the tabloids.

Although employee-executives may become extremely rich at the expense of public shareholders, they are not eager to have this known.

If their homes appear in Architectural Digest, it is often without their names or pictures.

There are some professional executives, like Lee Iacocca and Jack Welsh, whose egos drive them to write books and seek the limelight, but most hired-managers stay in the shadows.

Hired-managers gradually discovered how to chisel with impunity

Hired-managers have learned to loot over two generations, gradually, as the individual holdings of the ultimate owners have become smaller and smaller and as shareholders have become separated from management by multiple layers of fiduciaries, trustees, and boards of directors – holders of proxies through mutual funds, 401(k) plans, and retirement trusts.

The avaricious ethos of employee-executives developed slowly over decades of testing the vigilance of ever more distant public shareholders.

Hired-managers gradually discovered how to chisel with impunity. In the 1960s, their greed was limited to private planes, fancy offices, and executive benefits.

By the 1990s, they brazenly paid themselves multi-million dollar salaries – sometimes hundreds of millions of dollars – and exploited every opportunity to filch shareholders' assets, using contracts with unconscionable severance agreements, post-separation consulting fees, special retirement schemes, subsidized loans, multi-million dollar insurance policies, retention bonuses, and side-payments from affiliated companies.

By the 1990s, hired managers brazenly paid themselves mult-million dollar salaries.

Aided by large accounting firms, management remuneration consultants, lawyers, proxy solicitors, fund managers, investment bankers, lobbyists and public relations experts – all paid by the corporation – hired managers have been able to take money from small shareholders without fear of prosecution.

Today, thanks to Congressional pressure, the SEC makes information on management remuneration more readily available via the Internet, republished by magazines like Forbes and Business Week.

The Enron scandal, the fall of Arthur Andersen, and the crash of 2000, have introduced a slight shift in the political landscape.

If a mob eventually rises up against executive greed, the structure of the U.S. capital market will undergo a transformation that will be significant in Capital Flow Analysis.

However, it will take much more than Congressional hearings, modified accounting standards, and a few show-trials to change management behavior when ownership of corporations is so widely dispersed and, in essence, powerless.

The ascendancy of hired professionals to the executive suites of listed companies and their gradual corruption is part of the explanation for the long bull market of the 1980s and 1990s.

However, shareholders would not have tolerated the extravagant behavior of hired-managers if it were not for the connivance of government and financial intermediaries and the ardent support of apologists and spinners of fanciful theories in the great universities.

There are long historical trends and deeply rooted intellectual foundations that explain and, in a sense, justify the attitudes of today's employee-managers.

Essay: continued >

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